Diversification is one of the key components of a successful investment portfolio. By buying an index fund, an investor can get a diversified selection of securities in a single easy, low-cost investment. Investing in index funds is considered one of the safest strategies of investment as index funds provide exposure to thousands of securities in a single fund, hence lowering the overall risk through broad diversification.
By investing in companies with various market capitalization and sectors, the equity portfolio of investors gets diversified, lowering the risk in equity investing. Investment in index funds mimics stock market indices like the NSE Nifty, BSE Sensex, etc. Rather than attempting to beat the market, index funds target to provide returns that match the performance of the market; thereby, the returns from an index fund are similar for all investors holding the same fund. In general, investing in index funds is simple, cost-effective and transparent, and investors can get the best return on their money through such funds.
Here are some key benefits of investing in Index funds:
Lower expense ratio and low fees
Unlike actively managed mutual funds, Index funds usually involve lower expense ratios, and investors get the opportunity to invest more of their money where it will do the best for their portfolio.
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Index funds are passively managed and involve lesser buying and selling of individual securities than actively managed mutual funds. Thereby the tax liabilities on such funds reduce significantly, and over the time investors can get more after-tax returns.
Easy to manage
Index funds don’t change their asset allocation easily, making them easier to manage than actively managed mutual funds. In simpler words, while an investor invests in index funds, his / her asset allocation remains the same until the investor decides to change it him/herself or until another manager takes over from the current one.
Since the investment in the index fund is automated and is a law-based process, the amount to be invested in index funds of different securities is specified in the fund manager’s mandate, thereby eliminating the chances of human discretionary bias in investment decisions.
Key things to consider before investing in Index Funds
Risks and returns
Index funds are passively managed funds that track a market index, thereby being less volatile than actively managed funds. Even during a market rally, the returns from the index funds are more likely to remain good. However, there should be a decent mix of index funds and actively managed funds in an investor’s equity portfolio. Market experts suggest that investors should switch their investments to actively managed funds during a market slump. One of the key components investors should consider before investing in an index fund is to look for the ones with the lowest tracking error since the index funds replicate the performance of the index and the returns are similar to the index.
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The biggest advantage of index funds is their low expense ratio since they are passively managed. There is no need to create an additional investment strategy or research to find stocks for investing.
Though there are certain tax benefits of investing in index funds, it should also be noted that the index funds are equity funds and are subject to dividend distribution tax and capital gains tax.
(By Mahesh Shukla, Founder & CEO, PayMe)