Index funds are the types of mutual funds that passively track the portfolio of any specific stock market index. You may follow some big financial investors and check their portfolios to know where they are investing. Similarly, index funds invest in the indices that are famous or big in the stock market. In this blog, we’ll go through the details of index fund meaning, the steps to invest, and the pros and cons of investing in them.
What is an Index Fund?
Index funds have to invest at least 95% of their assets in the stocks of a particular underlying index. For example, Nifty 50 index funds invest in the stocks of Nifty 50 in the same number and weightage as the index. It means that index funds create a mirror image of the underlying index.
These funds are known for providing readymade diversification benefits along with the low cost of investing. In these funds, the fund manager is not actively involved in the research of stocks but rather follows the copy-and-paste approach. In actively managed mutual funds, the fund manager seeks to generate alpha returns while in index funds, the fund manager only looks to give average market-based returns.
WHY SMC
- 20 Lac+ unique clients
- 33+ Years of Serving
- Advance Technical Analysis
- Free Demat Account
How to Invest in Index Funds?
Index funds provide an indirect way to invest in numerous stocks without the stress of analyzing them and also in a cost-effective way. So, let’s go through the steps to invest in these funds and factors to consider before investing in them.
1. Choose a Stockbroker
The first and foremost thing is to open a demat account with a stockbroker that offers index funds and also provides complete information about each fund. You can open a demat account with SMC Global Securities and explore the index funds.
2. Look for the Index Funds Returns
After that, check the returns of the index funds in the last 3, 5, or 10 years. This helps you gauge the consistency of index funds returns and pick the funds that are generating higher returns than the average returns in this category.
3. Analyze the Fund’s Expense Ratio and Tracking Error
The expense ratio tells you the cost you need to pay to buy the units of an index fund which also affects the returns at the time of redemption. If an index fund has a lower expense ratio than the category average ratio, then this fund can be chosen.
Another thing to consider is the tracking error of an index fund. Tracking error measures how close the fund’s returns are to the underlying benchmark index’s returns. The higher the tracking error, the greater the difference between the returns. Hence, it is good to select a fund that has a lower tracking error.
4. Understand your Risk Tolerance
WHY SMC
- 20 Lac+ unique clients
- 33+ Years of Serving
- Advance Technical Analysis
- Free Demat Account
Risk tolerance helps you understand how much losses you can bear in the volatile market. People who are starting off or take a relatively moderate risk can invest in index funds that track the broad-based stock market indices such as Nifty 50. These indices include the stocks of large companies that are highly liquid and are slightly safeguarded from market impacts.
If you want to capitalize on a specific sector or industry positives and have an eye on the market, then you can consider the index funds that follow sectoral indices such as Nifty Bank, Nifty Auto, etc. These indices can generate higher returns than the broad-based market indices but can be more volatile.
5. Know your Investment Objectives and Investment Tenure
It is important to know whether you want to invest for your retirement age for later years or you want to invest for a short period. If you are looking to invest for a short period, then you can go with a sector-specific index fund which can rise in the short term with new opportunities or a positive global outlook. If you have a long-term objective, say more than 10 years, then you can choose to invest in broad-based index funds.
6. Invest through SIP or Lumpsum
You can invest in index funds through two ways, SIP and lumpsum. SIP (Systematic Investment Plan) allows you to invest in installments while lumpsum provides a way to invest the amount in one go.
Though SIP provides the benefit of rupee cost averaging, lumpsum can provide great returns in the long term. The choice between the two is highly dependent on your budget, income stream, or investment objectives.
Benefits of Investing in Index Funds
Index funds provide several benefits that make them ideal to be a part of your investment portfolio. Here are the key advantages of investing in index funds:
1. Easy Diversification
Diversification is not easy to incorporate in a portfolio but with index funds, this benefit comes effortlessly. If the Nifty 50 index fund is investing in the bundle of stocks of Nifty, then it certainly comprises stocks from different sectors and industries. When one sector is underperforming, stocks from another sector provide a cushion that keeps the performance of the index on track and hence your invested index fund.
2. Automatic Rebalancing
In order to keep up with the diversification, rebalancing is always required. In an index fund, rebalancing is a fully automated process with the removal of stocks that are dropped from the benchmark index and similarly adding the stocks. Also, the weightage of each stock holding is changed in a fund based on the revision of the stock’s weightage in the benchmark index.
3. Cost-Effective
Index funds are more cost-effective than actively managed mutual funds, meaning that they have a lower expense ratio. This is because the fund manager is not actively involved in analyzing the performance of individual stocks and hence his fees get lower, and so is the expense ratio of a fund.
4. No Active Monitoring Required
These funds do not require active monitoring of the underlying portfolio and hence the index funds returns may resemble the underlying index’s returns. Over the long term, the market volatility gets tamed down and with a buy-and-hold strategy, you can earn great returns.
5. Fully Transparent
With the tracking of a specific index and investing in listed stocks, there is full transparency in terms of the fund’s composition. You can easily check the market analysis report of the benchmark index to get a fair idea of your fund’s performance.
6. Good for Long-term Plans
Index funds are suited for long-term plans like retirement planning or child marriage. Because over the long term, market indices often tend to rise and hence you can create wealth to lead a comfortable life. Instead of investing in individual stocks, index funds provide an indirect way to earn with the growing market.
Disadvantages of Investing in Index Funds
With so many pros, there are cons that you need to be aware of about index funds.
1. Less Control
These funds have lesser control and the fund manager cannot randomly invest in a stock that holds a positive outlook. These funds have to abide by the benchmark index constituents and hence, they have limited flexibility in terms of portfolio management.
2. High Risk
Index funds belong to the high-risk level and even if they have diversified portfolios to reduce the risk, they are much more suitable for investors with a high or moderate risk profile.
3. Returns Lag
Even though an index fund replicates the performance of a benchmark index, it is not necessary that it give the same returns as the index. This happens because the fund has to bear the transaction cost to add or remove the stocks. Also, there is a time lag when the index goes through any change and the same is replicated to the fund. This means that the index funds returns can be lower than that of the benchmark index.
Who Can Consider Investing in Index Funds?
WHY SMC
- 20 Lac+ unique clients
- 33+ Years of Serving
- Advance Technical Analysis
- Free Demat Account
Index funds are good for investors who are new to the market and want to test the waters of mutual fund investing. These funds are generally prone to less volatility than pure equity funds and also do not require deep analysis of asset allocation and composition.
They are also good for investors who want to spend lower charges and still want to invest in mutual funds. With the passive investment style, index funds come with a lower expense ratio than other active mutual funds.
Conclusion
In the world of mutual funds, index funds are passively managed mutual funds that track any specific index. Understanding your investment objectives or risk tolerance is key to start investing in these funds. With the benefit of automated diversification and a lower expense ratio, these funds are good for novice investors and those who are looking to fulfill long-term goals.
FAQs
Which Indian index fund is best?
Some of the best Indian index funds that have generated great returns in the last 10 years are the UTI Nifty 50 Index Fund, HDFC Index Fund – Nifty 50 Plan, Nippon India Index Fund – Nifty 50 Plan, etc.
Are index funds safe?
Index funds are not fully safe as they are bound to be affected by market fluctuations and their returns can also fall especially in the short term.
Which one is the best Nifty 50 Index Fund?
Bandhan Nifty 50 Index Fund is one of the best Nifty 50 index funds that also has a lower expense ratio.
WHY SMC
- 20 Lac+ unique clients
- 33+ Years of Serving
- Advance Technical Analysis
- Free Demat Account
How to start SIP in index funds?
You can start the SIP in index funds on a weekly, monthly, quarterly, or monthly basis. It helps you invest a small amount regularly without the need for continuous evaluation.
References:
https://www.livemint.com/mutual-fund/mutual-funds-4-key-factors-to-look-at-before-deciding-to-invest-in-index-funds-nifty-50-investments-stock-market-11711382987261.html
https://www.livemint.com/mutual-fund/mutual-funds-how-to-select-the-right-index-funds-for-investment-portfolio-nifty-500-index-fund-investing-markets-11721149827256.html
https://www.mutualfundssahihai.com/en/what-are-index-funds
