Index Funds are passive mutual funds that mimic popular market indices.
So first let’s understand passive and active investing. When a fund manager has to take a call on which stocks to buy, which stocks to hold for the long term, which stocks to trade for the short term and which stocks to sell, then this is known as active investing. In short, the active fund manager is a busy man and is constantly on his toes.
On the other hand, the passive fund manager, focuses more on tracking an index. To begin with, the fund manager will create a portfolio of stocks that mirrors the index (Nifty or Sensex) in exactly the same proportion. He does not have to use any discretion on stock selection. If the weight of a stock within the index changes, the fund manager must buy or sell units of the stock to have its weight in the portfolio aligned to that of the index. The job of the passive fund manager is a lot simpler.
But you may wonder; does it really make sense to invest in index funds? Here are some features of an index fund which may help you decide whether to invest in index funds or not.
Features of an index fund
1. Index funds are the classic example of passive investing. Since the index fund is composed of index constituents, its portfolio mix becomes a lot simpler and predictable.
2. The index funds can generate healthy returns over a longer time horizon. The Sensex which was 173 in 1981, is now valued at 54,200 in 2022, a 306x jump. Which means that even an index fund on the Nifty or Sensex would have made good returns over the period.
3. A big feature of Index funds is that they overcome human interference. The fund manager of index fund, being a passive fund, just tracks the index.
4. Costs in an index fund are much lower. Since an index fund mimics its underlying benchmark, there is no need for an efficient team of research analysts which leads to low managing cost.
An investor has got to remember that index funds have not been great performers in the past. That is also because index funds in India have a higher tracking error.
Tracking error occurs because it is always not easy to hold the securities of the index in the same proportion and transaction costs are incurred by the fund in doing so. Despite tracking error, index funds are ideal for those who don’t want to take the risk of investing in individual stocks but would like to gain from exposure to the broader market.
For more details and investment advice, please contact your financial advisor.
Mutual Fund investments are subject to market risk, please read offer document carefully before investing.