As a beginner in the world of investments, you will want to invest in good stocks with potential returns having a low expense ratio, would you not? To do so, let’s understand what are Index Funds, how they work, and things you should consider before investing in Index Funds.
What are Index Funds?
Index funds are a type of mutual funds that imitate or mimic a stock market index based on its performance, for example, the NSE Nifty, BSE Sensex, etc. Many beginner investors find Index funds superior to other options as it offers greater diversification to your portfolio, has a relatively low expense ratio, and are comparatively exposed to lower risks.
Index funds are passively managed. Now, what do we mean by “passively managed”? In the case of Index Funds, the fund house or the portfolio manager follows the index of a market rather than going the extra mile to make decisions about investing in different stocks. The goal of an Index Fund is not to outperform, but to match the index of a market, say Nifty, Sensex, etc.
How Do Index Funds Work?
Let’s assume an Index fund is tracking the index of Nifty. The portfolio will have 50 stocks based on its composition, in the same proportions. While it gives greater diversification to your portfolio, it follows an index of the underlying benchmark which makes it a hassle-free mode of investment for beginners making it less inclined towards several risk factors.
As Index Funds are not actively managed, the returns on your investments are more or less equal to the market’s performance.
There are minor to major glitches in the scenario between fund performance and index, called — Tracking Error. It is preferably expected to bring down the tracking error as low as possible by the fund house or the manager.
Ideal Things To Consider Before Investing In an Index Fund
Let’s figure out some mandatory aspects to look at before investing in Index Funds.
- Risk Appetite — Before investing in Index Funds, research and analyze the risks that you might have to bear in case of a market downturn as these funds are passively managed, unlike mutual funds.
- Cost Of Investment — As the Index Funds are passively managed and no fund house or manager has to ideate and execute investment strategies manually, hence the expense ratio is comparatively lower. As per research, Index Fund with a lower expense ratio yields higher returns on investment.
- Return On Investment — As Index funds have the property of tracking the performance and matching the index of a benchmark, the value of your fund cannot outperform the value of the index, as it happens in the case of mutual funds (actively managed). Returns will be more or less equal to that of the index. Take your share of time to explore funds with minimum to zero tracking error to avoid deviations.
- Financial Goals — It is crucial to have Financial Goals before investing in any fund. The horizon can be short, intermediate, or long based on your goals and ambitions. Index funds are ideal for investors with long-term goals as the index keeps fluctuating. As these funds are purely based on the market performance of an index, it is ideal to stick around for 7+ years to gain good returns on your invested Index Fund. These funds are capable of generating ample wealth for you to achieve your goals.
We hope this article served its purpose of generating awareness on Index Funds and everything you should know about Index Funds as a beginner.
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