Let us first understand what an index is. You might have heard names like Nifty, Sensex etc. These are nothing but indices. Nifty 50 contains the top 50 companies in India, constituents of Sensex are top 30 companies in India. Similarly there are indexes based on the category of business. For example, Bank Nifty constitutes top banks in India. Some other indexes are Nifty Metal, Nifty Pharma etc.
An index fund is a type of passive mutual fund that copy pastes the index. Basically the fund house collects money from investors and invests in the companies that make up the index. The reason why index funds are called passive mutual fund is because the fund manager doesn’t need to make excessive research and find out the good stock. All she / he does is copy paste the companies in the index. Whereas in an active mutual fund the fund manager and others under him do excess research to find out good stocks that give splendid returns. As index funds are passive, it also means that the expense ratio is low. Expense ratio is the charge that fund house charges. Expense ratio of active funds are higher than expense ratio of passive funds.
Some of you might be thinking of investing in active funds, right ? Well the problem with active funds is that the fund manager has to pick stocks that outperform the index. As the index already contains the top companies, outperforming the index is not that easy. Also if fund managers make wrong decisions then you tend to lose money. So many people prefer passive funds as they are direct reflection of the economy. Also there’s something known as defensive index which means that the index performs decently even during recession. Fast Moving Consumer Goods (FMCG) is one such sector. Fast moving consumer goods includes items like toothpaste, soap, shampoo, biscuits, noodles etc. people tend to spend money on these even during bad times, so they are considered defensive sector.
One can invest in index funds via mutual fund route or via Exchange Traded Fund (ETF). I personally prefer ETF route. Let’s understand what ETF is, it is nothing but the same mutual funds that are listed on the stock exchange. ETF can be traded just like stocks during market hours. The problem with ETF is liquidity. If the volume of ETF that gets traded is low then entry and exit is difficult. I own small quantity of ETFs so it isn’t a hurdle to exit and besides that I own ETFs that are traded in decent volume. It is necessary to own a demat account if you want to invest via ETF route.
Also there is something known as Tracking Error when it comes to index funds. Sometimes the companies in the index gets replaced by different companies, during that time even the fund manager has to replace the stocks with new companies in order to mirror the index. As we know there’s something known as volatility, the price at which the fund manager buys these new companies may be slightly higher. Therefore, the return on index fund tends to be slightly lower than the actual index. For example, Nifty may go up by 12% in a year but the index fund goes up by 11.8 percent. Also there can be other reasons for tracking error, I’ve mentioned only one in this post.
If you plan to invest in index fund, then look for funds with less expense ratio and lower tracking error.
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