Index funds have been around in India for a couple of decades now, but have started gaining more and more popularity recently. According to Morningstar Research in the United States, for 2018, index funds saw an inflow of $458 billion while actively managed funds saw an outflow of $301 billion. Similar trends are emerging in India as well.

What is an index fund and how does it work?

An index fund is a type of mutual fund that mimics a given financial market index eg. NSE Nifty,  BSE Sensex etc. There is an index fund for nearly every existing market. A financial index typically consists of a portfolio of stocks with each stock assigned a weightage. An index fund mimics an index by investing in the same set of stocks in the same weightage as the underlying index. Such funds are therefore a passive form of investment, where, unlike an actively managed fund, the investment strategy does not change frequently.

Advantages of an index fund

Lower Cost: Since index funds are passively managed, they are inexpensive in terms of their operating cost (a.k.a. expense ratio). This is because the fund manager does not need a team of analysts or researchers for stock-picking and market-timing. Good index funds offer an expense ratio in the range of 0.2%-0.3% while actively managed funds typically charge 1.5-2.5%. This could mean a significant difference in your overall returns depending on your portfolio.

Diversification: Diversification is a key aspect of an individual’s investment portfolio. A well diversified portfolio is less volatile and a safer mode of investing. Index funds provide a broad market exposure as they invest in all the stocks that form a given index and as an investor you don’t need to worry about diversification.

Better Returns: Generating returns better than the market is extremely hard. All actively managed funds try to outperform the market but few end up doing that. For instance, in the last 5 years only 11 % of actively managed large cap funds in India have performed better than the benchmark index. A higher expense ratio of these funds also plays an important role in overall returns. Index funds tend to perform better than most funds in the long term. So, if you’re looking for investing in a fund for the long term then index funds are the way to go.

Things to keep in mind while choosing a fund

  1. Expense ratio – Different index funds offer different expense ratios. The lower the expense ratio the better.
  2. Tracking error – is the difference between the actual returns of the portfolio compared against the benchmark index. It’s an indication of the performance of the fund. Even though index funds are perfectly indexed against the benchmark, some divergence can creep in. A positive tracking error means that the fund has performed better than the benchmark and vice versa.
  3. Benchmark Index – As there are index funds for virtually every market index, it’s a critical factor in decision making. A large-cap based index (Nifty 50, Sensex) may be more reliable and consistent. While a small-cap index (NIFTY Smallcap 100, BSE Smallcap) which may offer higher returns but that comes with an increased risk.
  4. Buy direct – Like all mutual funds, index funds can also be bought in two modes – direct (via the fund’s AMC) and regular (via a distributor). A regular fund may charge as high as 2% as commission for the distributor, making the overall returns lower. Direct funds is the way to go.
  5. Market trends – A bullish market will always give a positive return while a bearish market will give a negative return. This is because an index fund mimics the market despite the underlying market conditions. Make use of an SIP to 
  6. Duration of investment – Markets may be prone to fluctuations in the short term but are generally bullish in the long term. Invest for the long term to get reliable returns.

Happy indexing!

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