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Finance

Things to know about index funds

Many investors want to invest for the long term but lack the expertise or time to select individual stocks. Index funds can be a great solution in such situations as they offer low-cost diversification, broad market exposure, and hassle-free portfolio management. These mutual funds aim to replicate specific index performance, like BSE Sensex, Nifty 50, or Nifty 500.

Investing in an index fund can be a smart move for both new and experienced investors. However, beginners particularly benefit from these mutual funds because it eliminates much of the research that needs to go into individual stock investing. Despite several benefits, there are some aspects that every investor should know about index funds, such as their asset allocation strategy, the role of fund managers, how they work, associated risks, and ways to invest in them.

Having said that, let’s explore the most important things to know about index funds.

  • Allocation strategy of index funds

Index funds allocate a significant portion of the invested corpus to securities that mirror the composition of the chosen index. The remaining may be kept in cash and money market instruments to manage liquidity and meet redemptions. This strategy helps the fund closely track the index’s movement and benefits from the broader market’s growth potential.

  • Role of an index fund manager

Unlike actively managed funds, where the fund manager makes investment decisions, index funds follow a passive investment strategy. The role of an index fund manager primarily involves maintaining the fund’s portfolio in line with the chosen index. Any future inflows into the fund are distributed in the same proportion as the original index. This approach simplifies decision-making for investors, as they don’t need to concern themselves with frequent market analysis.

  • Diversification for balanced growth

Diversification, the “don’t put all your eggs in one basket” approach is often recommended by financial experts to help investors achieve long-term goals. Diversification is a major advantage of index funds.

For example, the Nifty 50 Index mirrors India’s top 50 companies listed on the NSE or National Stock Exchange. It includes stocks from the healthcare, infrastructure, automobiles, banking, pharmaceuticals, and IT sectors. By investing in the Nifty 50 or similar index funds, you get automatic exposure to multiple large and successful companies, which mitigates the impact of poor performance by any individual company on your portfolio.

  • Low fees, high value

Index funds typically have lower fees compared to other types of mutual funds. This is because index funds are passively managed and rely on predetermined criteria. The fund manager simply tracks the index it follows. Since there is no active management involved, the fees are lower. The lower fees can significantly impact your overall returns over the long term, making index funds an attractive option for cost-conscious investors.

  • Risks associated with index funds

While index funds offer several benefits, there are risks as well. One such risk is known as “tracking error.” This refers to the possibility that the fund’s returns might slightly deviate from the index it’s meant to mirror due to factors like fund expenses, cash balance, or problems in buying/selling underlying index stocks.

Additionally, index fund investors have no control over the asset allocation within the fund as the holdings are determined by the index it tracks. So, investors can’t customise their mutual fund portfolio as per their preferences or exclude stocks they may not want to invest in.

 

How to buy index funds in India

You can invest in index funds through digital platforms offered by mutual fund houses and banks. Various mutual fund investment apps are also available. Simply open these platforms and go to the mutual fund section. Select the right index funds, and choose your investment mode, which can be a lump sum or systematic investment plan (SIP) as per your preferences. Once you have invested, you can easily monitor your growth through these digital platforms and make necessary adjustments.

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