An index fund is a mutual fund that replicates the portfolio of an index. Often these funds are known as index-tracked or index-tied mutual funds. These funds are affordable and well-diversified, and they generate good returns over a period and sometimes outperform actively managed funds. Let us discuss the same in detail.
What are index funds?
An index is a group of securities defining a market segment. Index funds are those funds which invest in stock market indices in the same shares and in the exact proportion. They are passively managed where the fund managers intervention is very limited. There are two popular indices in India: BSE Sensex and NSE Nifty. Index funds basically track these indices. The funds that track these indices contain the same investments in approximately the same proportion as the index itself. This way, when the index as a whole performs well, the value of the fund increases alongside it, which boosts the balance of your portfolio. Some indexes are tailored to specific sectors, geography, and stock exchanges.
The major advantage of investing in index funds is that your portfolio is diversified from the very beginning, minimising the chances that you will lose your money. For instance, an index fund that tracks the BSE 500 has 500 different shares. The performance of these different shares will vary and fluctuate over time, but when your money is spread out among so many shares, these ups and downs are smaller.
Expense ratio refers to the annual fee that all mutual funds, including index funds, charge their shareholders or unit holders. This is usually a percentage of the total assets you have invested. For instance, if you have Rs 1,000 in a mutual fund with a 1% expense ratio, you pay Rs 10 per year to own it. Note that you may not see this Rs 10 deduction on your statement.
Instead, it is simply taken directly from the fund assets, and so the reduction shows up in the form of a lower net asset value (NAV) for fund units. Actively managed mutual funds often have expense ratios between 1% and 2% because portfolio managers are responsible for picking the investments and actively doing the buying and selling. Contrary to the above, index funds are passively managed. By their design, investments within the fund rarely change. So there is little work for portfolio managers leading to lower charges.
Low risk tolerance
Index funds are ideal investment vehicle for investors who are risk-averse and want reasonably predictable returns. As an investor, if you wish to participate in equities but do not wish to take the risks and vagaries associated with actively-managed equity funds, then you can choose an index fund. These funds will give you returns matching the upside that the particular index sees. However, if you wish to earn market-beating returns, then you can opt for actively managed funds. To conclude, index funds are meant for investors who wish to invest in the broader market and want more diversification and lower costs. A well-diversified portfolio with good stocks and lower costs associated with passively managed funds should translate into better returns for investors investing in index funds.
(The writer is a professor of finance & accounting, IIM Tiruchirappalli)