Investors today are spoilt for choice when it comes to equity investment. Apart from direct investing, investors can opt for equity mutual funds, index funds or an ETF to take exposure to domestic or international equities. Investing in an index fund has been an encouraging trend over the last couple of years. This is evident in the increasing retail participation in equities through the index fund route. Over the previous year, the index fund’s assets under management have seen a 259 per cent rise to Rs. 94,589.5 crore from Rs 26,332.7 crore on July 31, 2021. In the same timeframe, folio count too has improved by 92 per cent.
Workings of an index fund
An index fund is a type of mutual fund that seeks to replicate a market index. For example, a Nifty 50 Index Fund will replicate the Nifty50 index in terms of its constituents and returns. In effect, an index typically brings together the performance of a basket of securities, which will represent either a sector or a market segment.
So, if you are an investor who believes in the potential of the Indian economy and consequently the Indian equity market, one of the easiest ways to play the Indian growth story is by investing in the benchmark indices of the equity market, such as the S&P BSE Sensex or the Nifty50. However, buying each security of the index separately and continuously keeping track of them is tedious. So, investing in an index fund is easier as they provide an indirect investment option.
What makes index fund popular?
With increasing investor awareness, investors have realised the ease and benefit of investing in an index fund. From an investor perspective, the time spent on researching before investing drastically reduces when investing in an index. Also, one gets access to a well-diversified portfolio. Today, a wide variety of index funds are available across market capitalisations and sectors. So, an investor can easily take care of equity allocation using index funds.
In terms of returns, index funds will help generate returns in-line with the underlying index. So, if Nifty50 generated a 10 per cent return in a particular year, an investor too will get a 10 per cent return minus expenses and tracking error. Apart from this, the cost associated with index investing tends to be lower as the fund manager here is not actively picking securities. Also, there is no need for constant monitoring as any changes will be effected only when there is a change in the index composition. All these factors aid in keeping the cost associated with fund management on the lower side.
Another advantage of an index fund is the elimination of bias when it comes to making an investment decision. Since there are no active decisions to be made by the fund manager, there is no scope of the portfolio being affected by a fund manager’s investment decision as an index fund will simply replicate an index. Owing to this, the risk associated with an index fund is aligned with its underlying index’s risks.
Things an investor should be mindful of
Remember that this is a long-term portfolio creation when allocating to an index fund. Pick a fund of your choice and invest via SIP to streamline periodic investments. A short-term approach to index investing can be disappointing as the market in the short to medium term can be quite volatile in nature.
From time to time, there will be stocks and sectors in and out of vogue. By index investing, you may miss out on these as the index is put together basis logic and numbers. History has shown that logic and discipline prevail over transient matters such as investing in recently trending sectors.
While the index fund aims to replicate an underlying index as closely as possible, it may not always be possible. The variance in benchmark and index fund returns is known as a tracking error. The fund manager constantly tries and ensures that tracking error is as minimal as possible.
(The author is Head – Product Development & Strategy,