What are index funds? All you need to know
If you are looking to benefit from the upward market movement, index funds are a great way to achieve that. Index funds are passive funds that follow specific market indices like the Bombay Stock Exchange or the National Stock Exchange of India.
For instance, if an index fund is benchmarked against the BSE, its portfolio composition will mirror the holdings of the BSE. This implies that it invests in companies similar to BSE. This enables the index fund to move up and down as BSE does.
You must note that these funds are managed passively, and the fund manager simply replicates the movement and changing composition of the benchmark.
No new research or analysis is brought in to evaluate whether investing in a certain company will help the fund in the long term.
Index funds are formulated and popularised on the basic premise that in the long run, stock markets will rise, and hence the index fund that closely mimics the original benchmark will also rise and bring growth to the investor portfolio.
There are index funds that are benchmarked against different stock market indices and against different sectors. These give you the option to choose the segment of your interest.
What makes index funds different?
According to Warren Buffet, index funds are a great place to park your money if you are looking at safe yet growth-oriented stock market options. This advice is based on a couple of facts that make index funds attractive to investors who do not want to shift their funds around very aggressively:
- Index funds are passively managed
- Index funds have a low expense ratio
- Index funds match the profits and losses of the markets at large. And usually tend to perform equivalent or slightly lower than the benchmark
- Index funds are invested on the premise that the market will always outperform any single stock
Investments in the index funds will over a period of time keep your investments safe and growing at a steady pace as the economy and the market grows. Hence, these are recommended for investors close to retirement as good long-term investment options.
How to invest in an index fund in India?
Investing in an index fund is similar to investing in any other mutual fund. It is important for you to understand what you are investing in, and not just put your monies into some random investments.
As index funds are usually long-term investments and passively managed, it is important for you to be sure that the fund you select mirrors the stated index well.
Research: Research and analyze the index fund’s performance over the past few years against the benchmark index.
Check up on future opportunities: Look at how the market/industry you are planning to invest in is expected to grow in the future. You must understand the opportunity for the segment that your index fund will be investing in.
Map your investment goals: Check whether the overall portfolio composition of the fund matches your own investment expectations: high growth, safety, assured returns, and so on. Pick the one which is closest to your investment and returns expectations.
Check on fund expenses: Fund expenses must be studied and understood carefully especially if you are looking to shift large funds. High fund expenses could increase your trading costs unnecessarily over time.
Risks and costs associated with index funds
Index funds move as the market moves, so it hardly ever outperforms the market.
It has little flexibility in cases of market crashes, the fund manager is not typically permitted to trade as a reaction to falling markets.
If the index fund does not truly mirror the benchmark index, it could affect your returns in the long run. This makes prior research very important.
It is worth noting that index funds with the lowest expense ratios track the benchmark index more accurately than others in the market.
Word of caution
Balance your portfolio with a combination of index funds and actively managed funds. This will help even out any major downsides that come with falling markets and bring more stability to your returns.
Be prepared to remain invested for up to a minimum of 7 years in the index fund if you wish to see some decent returns.
A few examples of popular index funds in India are:
- IDBI Nifty Junior Index Fund Growth
- ICICI Prudential Nifty 50 Index Plan Direct-Growth
- UTI Nifty Next 50 index Fund Direct-Growth
Index funds are a great tool to build your child’s education corpus fund. With the Indian economy growing, these funds will give you the growth that comes with the expanding markets. Start today, but make sure you do your due diligence before you part with your money.