Basics of Index Funds, Features, and More

Mutual funds are best known for their benefit of diversification and the fact that they are professionally managed. Your money is in the hands of financial experts to track the markets closely and make important calls such as when to buy, sell, and hold securities to generate maximum returns and meet the fund’s objective.

However, this comes with two drawbacks. The first is that there is a fund management charge in the form of an expense ratio which can be high and eat into your returns. The second is that there can sometimes be biases in the decisions made by managers, or the strategy based on which they made certain calls would not pan out accordingly. This is where index mutual funds come in. They afford the investor all the usual benefits of mutual funds but in a more efficient way.

What are index mutual funds?

Index mutual funds have a portfolio that is constructed in a way so that it tracks the underlying securities of a stock market index such as NSE Nifty 50, BSE Sensex, etc. So, for instance, a Nifty 50 index fund would have the same asset allocation and composition as the Nifty 50 index. The basic objective of an index fund is to mimic the performance of its benchmark fund. It does not try to outperform its benchmark but simply replicates its returns.

It does not involve timing the stock market or active stock-picking – it involves passive fund management. The idea behind index mutual funds is to build a diversified portfolio that can be passively managed and mimics the stock market as a whole or a broad segment of it. Index mutual funds focus on matching the risk-return profile of the broader market with the strategy that in the long run, the market will outperform anyone, specific investment.

Features of index mutual funds

  • Low cost

One of the biggest advantages of index mutual funds is that they come with lower expense ratios. A mutual fund’s expense ratio includes all the operating costs that the Asset Management Company (AMC) incurs such as fund management fee, transaction costs, etc.

Since index mutual funds are passively managed and simply need to mimic the benchmark index’s performance, the involvement of the fund manager is low and the services of experts such as analysts are not required for stock picking. The fund manager also doesn’t trade holdings often, so the transaction fees and commissions are also fewer. This benefit is passed on to the investors in the form of lower expense ratios – most index funds tend to have an expense ratio of less than 1%.

  • Risks and returns

Since index mutual funds aim to replicate the broader market, they tend to be less volatile owing to their level of diversification. Depending on the type, index mutual funds have been seen to outperform actively managed funds in the past. However, it’s advisable to have a balanced mix of index funds and actively managed funds in your portfolio.

As for the returns, index mutual funds tend to generate similar returns to their benchmark index. While their goal is to replicate their benchmark index, they may not always be able to do so due to tracking errors. Hence, when you want to invest in an index fund, make sure to check its tracking difference percentage.

Key takeaways

Index mutual funds are an excellent option if you are looking for low-cost, passively managed investments for a long-term buy-and-hold strategy. They offer higher diversification, stronger long-term returns, and replicate the broader market’s performance. However, before you decide to invest in index funds, make sure to consider your current investment portfolio’s asset allocation, your financial goals, and risk appetite.

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