One good thing about mutual fund investing is that investors have a wide range of schemes to choose from. Based on their investment objective, risk appetite and investment horizon investors can consider a scheme that is ideal for their life’s financial goals. Every individual has some dreams and aspirations which can only be accomplished by building the corpus over the long term. And one of the best ways to create wealth over the long term is by investing in market linked schemes like mutual funds. Mutual funds try to generate capital appreciation by building a portfolio encompassing various securities and money market instruments.
Mutual funds can be largely categorized as actively managed funds and passively managed funds. While active funds like ELSS, large cap, liquid funds, etc. are widely popular among the larger population, very few people are yet to find out about passive investing through mutual funds. Index funds and exchange traded funds (ETFs) offer passive investing through mutual funds.
Today we are going to discuss index funds and talk about 5 things every aspiring must know about this passive fund.
- What is an index fund?
An index fund is an open ended mutual fund scheme whose underlying portfolio matches the components of a market index, such as the NIFTY or the SENSEX that it is tracking for generating returns. Since every listed company stock has a different weightage in an index, the portfolio of an index fund is designed in a way to replicate the index. While active funds try to outperform their underlying benchmark, index funds try to replicate the performance of their benchmark or index, not outperform them.
- How do index funds work?
As mentioned earlier, the index fund invests in a diversified portfolio of stocks, however, there is one difference between stocking picking for active funds and index funds. While other equity funds can invest in a wide range of stocks belonging to various sectors, industries and having different market capitalization, index funds only invest in stocks that are listed on a particular index. The fund manager cannot manually pick stocks and the portfolio of the index fund mimics that of its underlying index and holds stocks in the same percentage as they are in the index. Due to this, the NAV (Net Asset Value)of an index fund moves in accordance with that of the index that it is tracking. Any noticeable change in the benchmark can immediately be witnessed in the index fund’s NAV.
- What is the investment objective of the index fund?
The investment objective of an index fund is to generate returns that closely mimic the overall returns of the index that it is tracking with minimum tracking error. As per SEBI guidelines, an index fund must allocate a minimum of 95 percent of the investible corpus in the underlying securities of the benchmark its tracking. The fund can invest the remaining 5 percent in cash and money market instruments
- Low expense ratio
Since these are passively managed funds, the fund manager of the index fund cannot build the portfolio through stock selection. An index fund’s portfolio of index funds replicates that of the index. Since there is no active fund management index like there is in active funds, index funds have a low expense ratio.
- Who should invest in index funds?
Investors who do not like their portfolios to be reshuffled from time to time and want their investments to stay void of any human biases can invest in index funds.