Warren Buffett, the legendary investor, is one of the greatest proponents of index funds and believes that they should be used for savings when you are in the later years of your life.
Based on their management, mutual funds can be bifurcated into two categories: active and passive. Index funds are primary examples of passive funds.
For many investors, meaningful investing translates to outperforming market returns. But it is imperative to understand that the stock market is a risky proposition and full of uncertainty. It means that your goal to beat the market may not always bear fruit. So, how do you ensure that you at least meet the market returns, if not exceed them?—Go with index investing.
This article answers what index funds are and why you should care.
You must have heard of S&P 500 or NIFTY 50. These are nothing but indices. In most cases, these indices replicate the performance of a specific sector or the market as a whole. But there is no direct way for an investor to invest in S&P 500, NIFTY 50, or any other similar standard. That is where index funds come into play.
Index funds are mutual funds that look to provide the returns generated by specific indices. These are passively managed funds that are said to have low operating expenses and low portfolio turnover. They also provide broad market exposure and are assigned a simple task—to follow the benchmark index irrespective of how it performs.
As mentioned above, index investing is a form of passive asset investment. Here, the fund manager is not actively involved in picking assets and trying to time the market. Instead, they build a basket of assets similar to the benchmark index. They mimic the performance of benchmark indices and therefore have a holding identical to the index’s composition.
Given that these indices do not change their composition frequently, the manager can manage the funds passively. Moreover, any significant change happens only when the assets in the index or their weights are changed. In such cases, the manager has to rebalance the fund’s portfolio to ensure it remains in sync.
Historically, apart from an accepted tracking error, most index funds have been able to replicate the performance of their benchmark index.
An index fund is like a small-scale depiction of full-fledged architecture.
Apart from their low TER (total expense ratio) and an accepted tracking error of around 0.1%, these assets have been able to replicate the performance of the benchmark index and have provided similar returns to the investors.
Indian investors can even invest in index funds tracking global indexes, such as NASDAQ and the HangSeng index.
Now that you know the basics of index funds and how they operate, the next step is understanding their types.
As the name suggests, market capitalisation index funds track the performance of companies with the largest market cap. Here, most of the AUM (assets under management) is invested in large-cap companies and only a small portion is allocated to mid-cap and small-cap holdings.
Broad market index funds replicate the performance of the overall stock index. These low-expense options offer you tax benefits. They are one of the most popular index-investing opportunities.
Earnings-based index funds are portfolios based on the profits generated by companies. These can be of two types – growth and value. While growth funds look to invest in profit-making businesses, value funds focus on finding stocks trading at a lower market price than their earnings.
As the name suggests, bond-based index funds solely look to replicate the performance of the top bond options in the market. They invest in a combination of short, intermediate, and long-term bonds.
Index investing has grown popular over time for a plethora of reasons:
Investors with no prior investing experience can also invest in these funds and eliminate the need for them to pick and manage their assets. So, if you are bullish on a specific index but do not know how to replicate it on your own, you can consider investing in an index fund tracking it.
Since these are passively managed funds, the fund manager is happy to charge a lower expense ratio. It is because they invest in assets without indulging in heavy research, otherwise needed for active funds.
Given that these funds carry a low expense ratio, index fund returns replicate closely that of the benchmark index. As a result, it allows you to enjoy the returns of the market without having to invest separately in a myriad of assets.
Irrespective of the funds you choose, you only need to spend a few minutes deciding on the investment strategy while following index investing. You do not have to look for the correct weightage, nor do you have to worry about hedging. It allows you to save significant time you would have otherwise spent researching for the right assets.
Index funds are an excellent way for beginners and even the most experienced investors where you can generate close-to-market returns with limited research. Also, it is imperative to understand that index investing doesn’t guarantee returns. Several indexes have remained at the same levels or are the lower levels compared to a few years ago.
The best option is to limit its weightage to around 10%. However, given the volatility across sectors, it is vital to keep a constant track of your overall portfolio. For this, Jupiter has created a Portfolio Analyser. It is a tool that helps you find how sahi your mutual funds are, fund underperforming funds, discover hidden fees, and detect high risk. Click here to get your free Portfolio Analyser report today.
Index funds are an excellent option for those who lack time to find the right assets or are beginners with limited research abilities. It will help you replicate the market or sector-specific returns with ease.
Yes. Index funds have a fee, but it is significantly lower than that of active funds. The fee is less than 0.2%, whereas active funds charge around 1%. As a result, it helps you generate higher compounded returns over time, making them a popular investment option for investors.
While Nifty has given decent returns over the years, many indexes have stayed at a level and have not shown appreciation during the same period. So, it is vital for you not to invest it all and limit the weightage to around 10%