There is no one right way to choose between various investment options – but if you were to take the advice of the world’s most famous investor, Mr. Warren Buffett would recommend that you focus on costs and invest in low-cost index funds. So much so that this is exactly the instruction he has left in his will in order to manage his wife’s money after his death!
Index funds have become increasingly popular among investors in recent years due to their low costs and consistent returns. They’re an excellent pick to diversify your portfolio investing. In this guide, we’ll cover everything you need to know about index funds in India, including how they work, their advantages, and how to invest in them.
What is an index fund?
They are a type of mutual fund that tracks a specific stock market index, such as the S&P 500. The goal of index investing is to replicate the returns of the underlying index rather than trying to outperform it, which means they hold the same stocks in the same proportion as the index.
This is in contrast to actively managed funds, where a fund manager picks and chooses individual stocks to include in the fund.
These funds are constructed by purchasing all of the stocks in the index they’re tracking, which means they’re more passive than actively managed funds. This also means they have lower operating costs since there’s no need to pay a fund manager to make investment decisions.
How are index funds different from ETFs?
Index funds are also mutual funds, similar to ETFs. The difference between the former and an ETF is that the latter trades on stock exchanges, and you need a Demat account to invest in it. An index fund can be invested in without a Demat account through the mutual fund company or a fund distributor. This comes at an added cost, though, which is why the expense ratio of an index fund is higher than that of an ETF.
How do index funds work?
They track the returns of an index by investing in exactly the same stocks as in the index – and in exactly the same weightage. For example, if the Nifty-50 has Infosys with a 6% weightage – the index fund which tracks the Nifty-50 will also have Infosys as 6% of its portfolio. This way, these generate returns that are almost identical to that of the index.
The goal of this fund is to provide returns that are consistent with the benchmark index they’re tracking. This means that if the index goes up, the value of the index fund should also go up, and if the index goes down, the value of the fund should also go down.
Index funds don’t need to hire a team of researchers & portfolio managers to monitor the market constantly; they are able to reduce costs significantly.
As such, they are far cheaper than most mutual funds – the difference being as low as 0.10% TER for certain passive funds & TERs of 1.50-2.25% for many active mutual funds.
Popular index funds indices:
Here are some well-known funds in India:
- The Nifty-50 & the Nifty-Next-50: These are 2 of the most popular indices in India. Together, they cover the 100 largest stocks by market capitalisation in India – all of which are classified as large-cap stocks.
- The S&P 500: Standard & Poor’s 500 is an index of performance of the 500 largest U.S. public companies.
- Nasdaq: The Nasdaq Composite tracks more than 3,000 technology-related companies.
How to Invest in Index Funds?
To invest in these funds, you first need to open an investment account with a brokerage firm or a financial advisor. Most online brokers offer commission-free trading for index funds, making it easy and affordable for investors to get started. Next, enter the ticker symbol of the fund you want to invest in and the amount you want to invest. Finally, review your order and click “submit.”
When choosing an index fund, it’s essential to consider several factors, including the fund’s expense ratio, tracking error, and diversification. Some of the top index funds in India include the Nifty 50 Index Fund, BSE Sensex Index Fund, and S&P BSE 500 Index Fund.
Why should you invest in these funds?
There are several advantages to investing in index funds, including:
1. Despite the ups and downs of individual equities, indexes often increase over time. You won’t earn bull gains with index funds during a bad market. However, even if one of your investments fails as the market soars, you won’t lose money on it.
2. Low fees. Since index funds need less labour than managed accounts, their expense ratios—also known as the cost of commissions and the cost of account management—are lower.
3. Aids with portfolio diversification. Index funds, like other mutual funds, distribute risk across a wider variety of assets, including both conservative and risky ones, as well as a wider variety of industries and asset classes.
smallcase, too, helps you with portfolio diversification as you can invest in 500+ readymade portfolios of stocks/ETFs.
4. Easy to comprehend. Index funds offer a “what you see is what you get” aspect, whereas investing methods can be quite complicated.
There are several misconceptions about index funds. Let’s examine these misconceptions and why they are false.
Misconception 1: Not diverse enough
Index funds are designed to provide investors with exposure to a broad range of stocks or bonds, making them highly diversified. For example, an S&P 500 fund holds 500 of the largest publicly traded companies in the US, representing a diverse range of sectors and industries.
Misconception 2: Not actively managed
While index funds do not rely on active management to select individual stocks or bonds, they still require careful management to track the index accurately. Fund managers must rebalance the portfolio periodically to maintain its alignment with the underlying index.
Misconception 3: Not as profitable as actively managed funds
While some actively managed funds may outperform index funds in the short term, numerous studies have shown that index funds tend to outperform actively managed funds over the long term. Additionally, they typically have lower fees, which can significantly impact an investor’s returns over time.
Investing in index funds is an excellent way for investors to gain exposure to a diversified portfolio of stocks or bonds at a low cost. By following the steps outlined in this blog, investors can easily invest in them and an take the first step towards building a successful investment portfolio.