Index funds are passively managed mutual funds tracking the underlying market index. An index fund allocates assets in a similar proportion as that of its underlying index, tracking the NSE Nifty and BSE Sensex indices with the goal of generating returns that mimic the performances of these indices.
Here’s the lowdown on a few factors that an investor needs to take into account prior to investing in an index fund:
Tracking error: There is a possibility in some cases that there is a slight deviation in the returns earned from an index mutual fund when compared to the benchmark index that it is mirroring. Referred to as a tracking error, the performance of index funds is inversely proportional to it. This means that the lower these errors, the better the index fund will perform.
Market volatility: Considering that index funds mimic a particular market index, the chances of these funds being prone to equity-linked risks are relatively less. However, taking into account the unpredictability in the stock market, in case faced with a downturn, the value of index funds will be subsequently affected in a bear market. An investor should be well-versed with the risks before investing in index funds. It is advised to mix both actively and passively managed index funds in order to create a balanced portfolio.
Expense ratio: Index funds usually have a quite low expense ratio compared to actively managed funds. Fund managers do not have to formulate any investment strategy when it comes to index funds. It is important to note that index funds with a relatively low expense ratio can potentially generate higher returns.
Investment horizon: Index funds may go through a lot of fluctuations considering the cyclic movements of the market. A long-term investment horizon helps an investor to average out the short-term volatility experienced in the market. Patience is the key when it comes to investing in index funds.
Index funds can be a suitable investment option for investors who remain conservative in their approach to investing and usually have a low appetite for high risk.
However, investors searching for market-beating returns can go in for actively managed funds. Those focusing on more diversification with lower operating costs and risks can opt for investing in index funds.
Rajiv is an independent editorial consultant for the last decade. Prior to this, he worked as a full-time journalist associated with various prominent print media houses. In his spare time, he loves to paint on canvas.