One of the most preferred investment schemes amongst Indians is mutual funds. They are an investment scheme in which an AMC collects money from a group of investors. Once enough money is collected in the fund, it is used to purchase financial securities. The target of investments in a mutual fund includes assets such as gold, money market instruments, stocks, and bonds. By purchasing a unit through a mutual fund, you get to own a small stake in all the investments that are considered a part of the fund. There are numerous types of mutual funds that are available as investment options and these different variants come with their own set of investment objectives. Apart from different variants of mutual funds, there are also different types of investment. One of these types of investment is passive investment.
Passive investing is a strategy in which you can maximise your income. It is possible by minimising your purchase and sale. This strategy of investing is done for long-term investment horizons, with minimal trading in the market involved. An alluring feature of this strategy is that it is considered cheaper and less complex. Moreover, as time passes by, it may produce after-tax results. A major goal of passive investing is to generate wealth progressively and regularly. Investors following this strategy don’t seek profits from things like market timing and short-term price fluctuations. This strategy is implemented with the underlying assumption that the market will yield positive results over time. Passive investors try either to match market or sector performance. The attempt to replicate the market performance is done by taking actions such as creating a well-diversified mutual fund portfolio of single stocks. The passive investment strategy tries to avoid things like fees. One of the prominent examples of passive investments is index funds.
What are index funds?
This mutual fund scheme variant is known for attempting to imitate the portfolio of a certain index, because of which it is also known as index-tracked mutual funds. The main aim of these funds is to both match and track the performance of a popular stock market index like NSE NIFTY 50 and BSE Sensex.
The strategy for asset allocation followed for these funds is the same as that of its underlying index. Just like as is the case in mutual funds, in an index mutual fund, an investor’s money is pooled with other investors by an AMC. Once enough wealth is accumulated, the fund manager opts to allocate them to different indices such as stocks and bonds. It is also important to note that under an index fund, the fund manager may or may not choose to invest in every component of an index. The main aim of these funds is to get an appropriate sample of every index. By doing so, a fund manager can effectively track index performance over time.
How do they work?
An Index can be described as a collection of securities that are known to define a particular market segment. As index funds track a specific index, they fall under the passive fund management category. In these that are passively managed, the income earned from the traded securities is linked to the performance of the underlying benchmark. Furthermore, there is no requirement for a team of research analysts to do things like picking a suitable stock and analysing market movements. Unlike actively managed funds in which you try to time and beat the market, an index fund is designed to match the performance of its index. The returns on index funds are linked to the underlying market index.
How to choose the best index fund?
You need to check two things before recognising an index fund as the best:
- Check if the expense ratio is low:
In an index fund, the fund manager doesn’t have a great role in managing it. All that’s required of them is to replicate the composition of the index in the portfolio. This is a reason why passively managed funds usually have a lower expense ratio in comparison to actively managed funds. The cost serves as an important differentiator as index funds tracking the same index will possibly have the same portfolio. The cost involved is known for having a direct bearing on the returns of the fund. An index fund scheme with a lower expense ratio than another tracking the same index will likely offer more returns. Therefore, it is prudent to look for an index fund with the lowest expense ratio.
- Check if it has lower tracking errors:
Whenever an index fund is unable to march the index movement, it is referred to as a tracking error. For example, an open-ended fund is tracking NIFTY, and it goes up by 90 basis points. But, the NIFTY itself goes up by 1 per cent. The difference between the two would result in a tracking error. As the objective of index funds is to track an underlying index, the lower the variance between the fund and the underlying index, the better it is.
