If you are willing to invest in equity mutual funds but wary of fund managers, Index fund is a better option. The index funds are equity funds that replicate a particular equity index by investing in the stocks that the index tracks. For all the first-time investors, we are outlining the “need to know” prior to investing in index funds.
Index funds, in contrast to actively-managed mutual funds, are passively-managed funds. Index funds invest in an index. Index funds invest in all the stocks (as in the index) in the same proportion as in a particular index. This means the performance of the index fund will mirror the index it is tracking. Except, for a small difference known as tracking error. As each stock has different weight in an index, the portfolio of an index fund is also allocated in a way to mirror that of the index.
The whole bedrock of index fund relies on the fact that investments are passively managed. Hence, low in cost i.e., the expense of the Index fund is much lower as compared to an actively managed fund. This strategy of building an equity fund portfolio also nullifies the risk associated with the fund manager. Events like a fund manager quitting the fund or taking wrong investment calls become irrelevant.
Index funds are ideal for those investors who prefer to take the market risk and not a fund manager risk. There are other factors too which put forth a strong case in favor of index fund investment:
- Zero Churning: Since the portfolio replicates a particular index, the churning of the portfolio is done away with. Leading to lower brokerage and transaction costs.
- Low Expense Ratio: As it involves the limited role of fund managers, the fund management charges are also lower in index funds resulting in the lower expense ratio than that of the actively managed funds.
- Traded on Exchanges: Normal funds can be bought and sold only at the net asset value (NAV) declared at the end of the day. In the case of index funds, traded on exchanges, one can buy and sell them any time of the day at the prices prevailing at that particular time. It enables one to take the price advantage not available in non-exchange-traded funds.
According to legendary investor Warren Buffet “A SIP investor in an Index fund will outperform 90% of investors”. This is truer in developed economies where the stock markets barely give single-digit returns and expense ratios become relevant in determining the net returns.