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Do you want to get rid of those under-performing mutual funds drilling a hole in your pocket?

Try Index funds!

An index fund is a mutual fund that imitates the portfolio of an index. These funds are also known as index-tied or index-tracked mutual funds.

An index is a group of securities defining a market segment. These securities can be bond market instruments or equity-oriented instruments like stocks. The popular indices in India are stock indices like BSE Sensex and NSE Nifty.

When an index fund tracks the Nifty, for example, its portfolio will have the 50 stocks that comprise Nifty, in the exact same proportions. This is a passive investment style that makes index funds passive investment options that track their respective index.

How are Index Funds different from regular funds?

Since index funds track a particular index, they fall under passive fund management. Regular mutual funds, on the other hand, are actively-managed mutual funds. In this, the fund manager decides which stocks have to be bought and sold in an active manner.

A team of research analysts helps to identify opportunities and in stock selection. A regular mutual fund uses an index as a benchmark for its performance, but it does not necessarily invest in the same stocks that form its benchmark index.

While an actively-managed fund strives to beat its benchmark, an index fund’s role is to match the performance of its index. Index funds typically deliver returns more or less equal to the benchmark.

However, sometimes there can be a small difference between the fund performance and the index. It’s known as the tracking error. Fund manager will try to reduce the tracking error as much as possible.

Should you choose an Index Fund?

Index funds are ideal for investors who are risk-averse and want predictable returns. For example, if you wish to participate in equities but don’t wish to take the risks associated with actively-managed equity funds, you can choose a Sensex or Nifty index fund.

These funds will give you returns matching the upside that the particular index sees. However, if you wish to earn market-beating returns, then you can opt for actively-managed funds.

Let’s take the example of a Sensex index fund and an actively-managed large-cap equity funds. Here we choose a large-cap equity fund to compare because the Sensex is made up of large-cap stocks and hence, a Sensex index fund will also be a large-cap fund.

Here is how the average returns earned by the large-cap equity funds category compare to the returns earned by Sensex.

Performance of large-cap equity funds versus Sensex
1-year returns (%) 3-year returns (%) 5-year returns (%) 10-year returns (%)
Large-cap equity funds 17.25 11.01 14.52 7.97
BSE Sensex 17.35 7.19 12.05 5.97

As on 25 October 2017

As the table shows, while the 1-year returns of actively-managed funds match the returns of the Sensex, over longer time periods, the former tend to do better. Moreover, these are category average returns. The top-performing funds within this category would have done much better.

Hence, the choice between an index fund and a regular mutual fund depends upon the your risk preferences and investment goals.

Benefits of Index Funds

The three key benefits of index funds are:

  • Low cost: Index funds usually have an expense ratio of 0.5% or even less. In comparison, actively-managed funds have an expense ratio of 1% to 2.5%.

  • Low risk: As discussed earlier, since index funds map an index, they are less prone to equity-related volatility and risks.

  • Low efforts: They don’t require extensive tracking. Since there is no fund manager involved, there is no need to look at the portfolio constituents. You don’t need to keep an eye on an index fund’s performance. They will always do as well as the index.

Index funds are amazing options during a bull run to earn great returns. However, you need to switch to actively-managed funds during a bear run. It’s because index funds may lose higher value during a market downturn.

It’s always advisable to have a mix of actively-managed funds and index funds in your portfolio.

What are ETFs?

ETFs or exchange traded funds are a type of index fund that are traded on stock exchanges, like equity shares of a company. To invest in an ETF, you require a demat account and buy units that are listed on a stock exchange.

ETFs don’t have an expense ratio, but you need to pay the brokerage charges to invest in them.

If you are considering a passive investment option, an index fund is a better option than an ETF.

How to choose an Index Fund?

The real differentiating factor between two index funds will be their expense ratio. If two index funds are tracking the Nifty, both of them will deliver largely similar returns. The only difference will be the expense ratio. The fund having a lower expense ratio will give marginally higher returns.

The other factor to consider while choosing an index fund  the AMC and for how long it has been running.

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