Mutual Funds: Index funds are good for first-time investors

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December 8, 2020 4:15 AM

If you are new to investing in equity and risk-averse, then investing in index funds is a good idea as it will provide you an exposure to a broad-based portfolio at a low cost

As the portfolio is based on the particular index, there is less churning of the portfolio.As the portfolio is based on the particular index, there is less churning of the portfolio.

The BSE-Sensex has touched an all-time high of 45,000, motivating many active equity investors to consider investing in index funds. Investing in such funds ensures performance identical to that of the index which is being tracked, and generally such funds have low expense ratio. Let us look at the same in detail.

Mechanics of index funds
Index funds are mutual funds with a portfolio made to manage or track the components of a specific market index. Such funds provide broad market and low portfolio exposure with comparative lower operating costs. These funds follow specific rules and standards irrespective of the ongoing status of the market. For instance, when an index fund tracks a benchmark index like Nifty then its portfolio will have the 50 stocks that comprise Nifty, in the same proportions.

For whom it is suitable
Index funds are generally suitable for investors who are risk-averse and expect predictable returns. One of the major advantages of this type of funds is that they do not require extensive tracking. These funds generate returns matching the upside that the particular index sees. Further, these funds are best suited for those investors who have a long-term investment horizon. However, if one wishes to earn market-beating returns, then one should not choose index funds.

Consider the following
If the idea of investing in index funds suits your risk appetite and investment goals, follow the tips below before making an investment. It is always a good idea to choose a broad-based index fund which helps you cover the majority of the actively traded stocks in the market. For instance, you may choose the Nifty top 100 index fund. If you are new to investing in equity and risk-averse, then investing in index funds is a good idea to start with as it will provide an exposure to a broad-based portfolio at a low cost.

Most of the index funds are also available as exchange traded funds. The advantage of investing in an index fund which is an exchange traded fund (ETF) is that these ETFs are listed on the stock exchanges like stocks. This makes it easy for buying and selling of the same. Investors should prefer those index funds that have lower tracking errors. This is basically the different between the performance delivered by an index fund and the index it replicates. Obviously, higher the tracking error, the less efficient is the index fund in consideration.

Other advantages
As the portfolio is based on the particular index, there is less churning of the portfolio. Hence, significant costs are saved on brokerage thus leading to less expense ratio compared to actively managed funds. With index funds, one can buy and sell anytime during the day at the price prevailing at that time. Hence, one can take the advantage of the price not available otherwise. Empirically, none of the index funds has shown negative results on a long term basis. This shows that index funds can limit the losses of the investors.

To conclude, the investment decision in an index fund solely depends upon individual investors’ risk preferences and investment goals.

  • Index matters
    Index funds are generally suited for investors who are risk-averse and expect predictable returns
  • Choose a broad-based index fund which helps you cover the majority of the actively traded stocks in the market
  • The advantage of investing in an index fund which is an exchange traded fund (ETF) is that these ETFs are listed on the stock exchanges
  • You can buy and sell index funds any day at the price prevailing at that time
  • Go for those index funds that have lower tracking errors

The writer is a professor of finance & accounting, IIM Tiruchirappalli

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