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How to Invest Better in Index Funds?

  • Rudri Rawell
  • Mar 25 2022
  • 6 minutes
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Index funds are the latest talk of the town among stock market and mutual fund investors alike. As markets remain volatile through the Covid-19 pandemic and the ongoing Russia-Ukraine war, these funds are fast gaining the attention of many due to their unique characteristics. Index funds invest in stocks that form part of the underlying index and in the same proportion as the index. The fundamental principle they follow is to mimic the index composition and performance. 

If you are looking to invest in index funds, here is all that you need to know to invest better in these.

What are index funds?

Index funds primarily invest in stocks that are constituents of a benchmark index, such as the Nifty 50, Sensex, etc. These are passively managed and therefore offer lower expense ratios or management fees as compared to actively managed mutual funds. 

How to invest better in index funds?

It is very easy to invest in index funds. Here is how an investor can go about it:

  • Choose an index that you want to track, like the Nifty or Sensex
  • Go through the various fund options that track the index
  • Pick a fund for investment based on criteria such as expense ratio, tracking error, and historical performance
  • Invest in an index fund easily through the Finity app

How to select the right index fund for investment?

Here are some tips that investors can follow while selecting the ideal index fund for investment:

  • Know the size and capitalization of the companies whose stocks the fund invests in. Since various index funds catering to various market capitalisations and themes are available, like Small cap index fund, mid or large-cap index funds, etc an investor must know personal comfort level with the risks of each and measure personal return expectations versus what the fund structure can offer.
  • Funds can be focused on specific sector such as consumer goods, technology, etc. There may also be funds that combine foreign stocks with domestic stocks. Therefore, an investor must carefully consider the composition of the underlying index before selecting a fund.

Despite the range of choices offered under the index fund bucket, an investor can invest in one broad stock market indice to achieve portfolio diversification. 

How does an index fund work?

To know how an index fund works, we must first know how a passive investment differs from actively managed funds. 

Actively managed mutual funds involve a fund manager who actively selects securities for buying or selling and makes decisions on when to transact. Since this requires time, effort, and substantial understanding of the markets, the fund will charge a management fee for investing in actively managed mutual funds. 

Passively managed funds like index funds, on the other hand, involve a strategy that requires a fund manager to set up a portfolio of investments reflecting the benchmark index. However, since the fund will only track the index, there is no active role of the fund manager. The performance of the index fund will mirror the index performance, thus eliminating substantial management fees, also known as the expense ratio. 

Reasons to invest in index funds

Index fund investments are easy and one of the most cost-effective wealth creation avenues for investors. By tracking and mirroring the performance of the financial markets, index funds can offer positive returns in the long run without requiring an investor to constantly monitor it.

Here are some of the top reasons why investing in index funds can be a sensible decision:

  • Easier decision making
    Minimal research time required since there is no need for an investor to evaluate individual stocks. An investor can simply rely on the fund’s strategy to invest in an index that comprises the stocks that he/she must invest in.
  • Diversification
    Since indexes constitute of multiple stocks or other instruments, there is sufficient performance diversification in the index.
  • Multiple options to choose from
    Index funds are available in many formats. There are stock index funds, bond index funds, etc. to suit different investment strategies of different investors. There are also focused index funds that concentrate on certain portions of the financial markets.
  • Pocket friendly
    It is less expensive to invest in these as compared to actively managed funds. This is because an index fund manager only buys stocks or other securities that are part of the underlying index.
  • Helps in long term wealth building
    Since these funds remain constant in terms of strategy and investment selection, investors can expect long-term capital growth that aligns with their financial planning. Overall returns from these funds do not get much impacted by short-term market movements.

Things to consider before investing in index funds

Despite the benefits listed above, index funds may not suit all investor expectations. Hence, some of the points that investors should consider before investing in them are:

  • Since index funds track the index, these cannot beat the market. They are designed to mirror the market’s performance and investors who expect comparatively superior returns should reconsider investing in these.
  • Investors should note that there is no loss protection in index fund investments. These track the index in good market conditions and bad. Therefore, when the market plunges, the index fund returns will also plunge.
  • It is not necessary that an investor will own stocks that he/she is interested in as far as index fund investments are concerned. The fund’s stock composition is entirely based on the index composition.

Conclusion

Index funds continue to attract more investors as people prefer to follow the market instead of beating the market in the long run. As these are still new in the Indian context, it is important for investors to know the best ways to invest in these after having sufficient knowledge about them.

FAQs

Are index funds difficult to understand?

No, index funds are not difficult to understand. In fact, these are far easier to understand due to transparency around stock composition.

Why is passive investing strategy better than active investing?

Passive investing involves lower fund manager discretion, lower expense ratio, and more transparency around portfolio composition. This is why it is preferred by many investors over active investing.

What passive funds other than index funds can I invest in?

ETFs or Exchange traded funds are passive funds that can be explored apart from index funds.

How much expense ratio is ideal for index funds?

Index funds generally have expense ratios below 1%. Investors should look for an index fund that has lower expense ratios as compared to other index funds.

Do index funds have lock-in period?

No, index funds generally do not have a lock-in period and investors can exit them at any time. However, investors must carefully look at the exit load applicable on the scheme.

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