One of the best ways to balance your overall investment risk is by diversifying your investment portfolio across various asset classes. Young investors often prefer having a fully equity-oriented portfolio as investments in stocks and equity-related instruments are known to fetch higher returns. However, the stock market is highly volatile in nature and since one’s investments are constantly exposed to the vagaries in the market, chances are that your portfolio may incur losses from time to time. Thus, depending on one’s risk appetite and investment objective it is better to diversify the investment portfolio across various asset classes like equity, debt, gold, etc. If you wish to invest in an equity scheme that offers diversification, has a low expense ratio, and offers high liquidity, you may consider investing in an index fund.
What is an index fund?
An index fund is a passive mutual fund that aims at generating returns by replicating the performance of its underlying index. The portfolio composition of securities in an index fund is exactly the same as the composition of securities present in the underlying index.
Features of an index fund
Low expense ratio: Passive funds like index funds and exchange-traded funds (ETFs) follow a passive investment strategy. The fund manager has very little say in how the portfolio is composed, neither does the fund manager actively buy or sell securities to generate returns. Since there is no active participation in managing index funds, they are known to have a relatively low expense ratio.
Diversification: Investors who fear investing in the stock market directly can consider investing in index funds. Index funds in a basket of securities thus building a portfolio of credible stocks with growth potential. Thus, by investing in index funds investors get exposure to a basket of performing stocks rather than investing in direct stocks where the concentration risk is very high.
Invest without a Demat account: To invest in other passive funds like ETFs, investors need to have a Demat account. But those rules do not apply to index funds as investors can invest in these market-linked schemes with a normal mutual fund account.
Free of human emotion: You already know that index funds replicate the performance of their underlying securities. They are not actively managed by a portfolio manager. This makes returns earned from index funds free of any human biases. The returns are purely based on the performance of the securities of the index and not based on any decisions taken by an individual.
How does an index fund work?
As mentioned earlier, an index fund mimics its benchmark which can be anything like a NIFTY50 or SENSEX30 or any other index. The index fund manager has no say in picking stocks while building its portfolio. Since this is a passive fund, the fund manager does not pick the stock to build the index fund’s portfolio. Index funds are designed in such a way that they replicate the performance of the securities in their underlying benchmark and try to generate similar returns with minimum tracking error. This is different than other mutual funds that invest in stocks belonging to various indices and do not stick to company stocks belonging to one particular index.
The NAV (Net Asset Value)of an index fund fluctuates in quantum with that of the index that it is tracking.
Index funds may offer a passive investment strategy, but do not guarantee returns. Investors must understand their risk appetite and accordingly make an informed investment decision.
