Index Funds: The Passively Managed Mutual Fund- An Overview

An index fund is a type of passively managed exchange-traded fund or mutual fund. It seeks to track the returns of a market index and imitates the portfolio of an index. Index funds invest in stocks that constitute the index in the exact same proportion. So, these are often known as index-tracked or index-tied mutual funds. Investors can enjoy broad exposure, goal diversification and low-operating costs. Index fund AUM grew by 590% since 2020 in India as COVID hit the markets. They are ideal to take care of long-term goals like retirement or purchasing a property. Here’s a detailed overview for an informed choice.

Benefits of an Index Fund

The best index funds have consistently overpowered other funds in terms of returns. Below are a few benefits of investing in index funds.

  1. The operating expenses are quite low. This is since low-cost index funds do not follow an active style of investing that tries to outperform a market with frequent sales and purchases of securities.
  2. Index funds try to match the returns offered by the underlying market unlike active funds that wish to outperform the underlying benchmark.
  3. Index funds follow a simple passive investing strategy. If the market goes up, your funds will also go up and investors can benefit from the same.
  4. Fund managers make sure the tracking error is kept to a minimum. This way the returns generated by the fund are similar to what the index delivers.
  5. Offers effective diversification since it spreads your investment across the broad market segment and benefits from multiple industrial sectors.

The top index funds are ideal for anyone who is not comfortable with the risks of actively managed equity funds. But you must be ready to stay invested for at least 3-5 years to be able to see considerable positive returns. Factor in risk appetite, investment objective and investment horizon before making a decision.

How Does an Index Fund Work?

The core components of an index fund are stock picking and market timing. They are less volatile than their counterparts, that is, diversified funds. The cash you put in an index fund is used to invest in companies that make up the particular index. This ensures a more diversified portfolio than buying individual stocks. At all times, the index fund portfolio mirrors that of an index, both in percentage holding and choice of NAV.
So, the NAV moves in line with the index it tracks. An index fund allocates 95-100% of the corpus into equity securities covered by the index. Only 5% may be kept in cash and money market instruments. It is necessary to keep the ‘tracking error’ in mind while looking at and comparing different index funds. The factors that impact the tracking error are change of index constituents, outflow/inflow in the fund, corporate actions and the level of cash maintained in the fund for liquidity purposes.

The ease of investing and low expenses make index funds a natural choice for investors in India. Before picking index funds to invest in, check the 1 Year CAGR % and 5 Year CAGR % to track the growth.

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