Things to know about index funds

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Many investors prefer a hands-off approach to investing. They don’t want the stress of constantly monitoring the market or trying to time their entry and exitperfectly. This is where index funds help. Index funds are mutual funds that offer a passive investing approach and allow you to invest without the need for active decision making.

But passive investing does not mean you can invest and forget about it. In fact, there are a few important things to know in order to maximise your returns and minimise risk with index funds. Having said that, let’s go into the essential aspects of index funds that every investor should know.

How does an index fund work?

Unlike active funds, where a fund manager makes decisions about which stocks to buy or sell, an index fund simply replicates the holdings and proportions of the index it follows.

For example, if the Sensex (or the chosen index) goes up by 8%, the NAV of the linked index fund will also increase by approximately 8%. Similarly, if the Sensex drops by 8%, the index fund’s NAV will also drop by around 8%. So, with an index fund, you can expect your investment to move in sync with the chosen index.

Ways to invest in index funds

You can buy index funds in India through lump sum and Systematic Investment Plans (SIPs).With the lump sum option, you can invest a large sum of money at once. SIP investment method allows you to invest small amounts at regular intervals, such as monthly, quarterly, or annually.

Most experts advise the SIP route as it helps investors start with low investment amounts and increase their contributions with time. You invest in mutual funds regularly regardless of market conditions which reduces the impact of market volatility through rupee-cost averaging. This way, you can bring discipline to your investments and accumulate wealth for different goals in a structured manner.

Who should invest in index funds? Features and benefits

  • Risk-averse and new investors: Since these funds follow a specific index, new investors who want to invest without choosing individual stocks can invest in index funds.
  • Cost-conscious investors: Index funds have lower expense ratios compared to actively managed funds. This means you keep more of your investment returns instead of paying high fees.
  • Investors who prefer diversification: There are different types of index funds with exposure to multiple assets, companies, industries and investment strategies. This helps reduce risk and increase stability.
  • Passive investors: With index funds, you don’t need to worry about buying or selling at the perfect time. You simply stay invested and let the fund track the index’s performance.
  • Long-term investors: Most experts advise investors to stay invested in index funds for a longer time to allow the market cycles to even out and bring returns.

Risks of investing in index funds

  • Tracking error: Oftentimes, the fund’s returns may not exactly match the index’s returns due to factors like fees, the timing of trades, or the fund’s composition. This difference is called “tracking error.”
  • No control over individual stocks or holdings: An index fund’s holdings are determined by the index it tracks. So, neither you nor the fund manager can’t customise the portfolio to your specific preferences or exclude stocks or sectors you may not want to invest in.
  • Missing expertise of a fund manager: Index funds rely on predetermined criteria. While this keeps costs low, it means you miss out on the involvement of a fund manager who actively selects investments and follows a structured investment strategy.

To wrap up

With benefits like diversification, consistent returns, low fees and risks, most experts agree that index funds are a useful addition to any mutual fund portfolio. At the same time, investing responsibly and familiarising yourself with essential aspects of index funds is important.

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