When we invest in index funds, we basically invest in stocks that are part of some index. An index consists of a bunch of stocks that represent a particular category. For example, we have the Nifty 50 Index which tracks the top 50 stocks of the NSE. Then there are multiple Mutual Funds that track the Nifty 50 Index and are known as Nifty Index Funds. There is also the BSE Sensex Index, Nifty Bank Index, and many other thematic index.
How Index Funds Work
Let’s take into consideration a Nifty 50 Index. Nifty 50 consists of 50 stocks in similar proportions. A mutual fund which invests in all the stocks that the index tracks is known as an Index Fund. This is also a type of passive fund in which the fund manager isn’t responsible to actively choose stocks for a fund. They just need to make sure to mimic the Index. This is different to an active fund, where the fund manager needs to make continuous choices of selecting stocks for the fund he is managing.
Benefits on Index Funds
There are numerous benefits of investing in index funds:
- Lower Fees and Expense Ratio – As these funds are passively managed without a lot of effort from the fund manager, these funds have very low fees and expense ratios.
- Tax Benefits – As the underlying stocks aren’t bought and sold frequently, these funds have reduced tax liabilities compared to an active funds.
- Great Returns – More than 90% of mutual funds haven’t been able to beat the Index in the last year. So it makes more sense to invest in the index itself. Historically the Index has given a compounded return of 15% in the last 20 years.
Things to Consider
Here are a few things to consider while investing in an Index Mutual Fund.
- As an Index Fund actually tracks an Index, it resembles the market. So if the market goes up, the fund goes up. And if the market goes down, the Fund goes down.
- In an index fund, the Fund Manager tries to mimic the Index. As because it can’t be done instantaneously, there might be a little difference between the performance of the index and the Index Fund. This is known as tracking error. Before selecting an Index Fund, make sure that it has a lesser tracking error.
- Expense Ratio is a small percentage that the fund house charges to the customer for managing the fund. As an Index Fund is passively managed, it has a lesser expense ratio compared to an actively managed fund. Make sure to find an Index Fund with a lower expense ratio.
How to Invest in Index Fund
To invest in an index fund, one needs to open an account with a mutual fund company. One can also buy the fund using Zerodha’s coin platform. You can open an account with Zerodha by following this link:
Conclusion
We can save a lot of money and hassle when we invest in index funds for the long term. With recent reclassifications of Mutual Fund schemes, Index Mutual Fund would become a significant player in the investment world.
It is also a great option who don’t want to take chances and are fine with long-term investments for getting market returns.