Now, as of June 26, 2022, the Sensex has risen by over 70% in the last five years. This could mean that if you had made the exact same investment in a portfolio that is similar in composition to the index, you could get similar returns.
But manually maintaining a portfolio similar in structure to an index can become a daunting task. This will require constant monitoring and intervention. Investing in index mutual funds is one possible solution to this problem. So let’s learn more about index mutual funds and see how they help in long-term wealth creation.
What are Index Funds?
index fund There are types of mutual funds whose portfolio is similar to the index they track. So, for example, an index that tracks the Sensex will have the same structure as the index. Here, these funds follow a passive management style as the role of fund managers is limited to creating a portfolio similar to that of the index, and does not require continuous intervention.
Since this fund tracks the index, its returns are very similar to that of the index, although there may be some tracking errors.
Now let us see how this fund works. An index is a composition of stocks that fit into a category. Here, suppose you are investing in an index fund that tracks the Nifty, the composition of the top stocks listed on the National Stock Exchange. As the name suggests, Nifty 50 consists of 50 components. Therefore, an index fund will have exactly 50 securities in its portfolio. In short, an index fund ensures that its portfolio is similar in composition to the index at all times.
But that doesn’t mean that index funds are limited to stocks. The portfolio of such funds may include equities and equity-related instruments, including bonds.
Index funds also have different goals. While a traditional, actively managed fund tries to outperform an index, the purpose of an index fund is to track the fund’s growth.
Will Index Funds Work For You?
As we discussed above, an index fund tracks an index as it is. This means the fund will have or will try to grow at the same rate as the index. If we take history as evidence, most of the major indices have a continuous upward trend. As stated above, in the last five years (till June 26, 2022), the Sensex has gained over 70%, and the Nifty has gained over 65% in the same time frame. This makes index funds a potential option for investors who are trying to get predictable returns.
When fund managers are involved, their opinions may inadvertently create bias when creating a portfolio. The manager is basically trying to outperform the index. Therefore, it may increase the element of risk. However, this does not apply to index funds, which makes it possible for investors looking for viable and low-risk alternatives to generate good returns.
Also, an important point to understand here is that since the fund tracks the index, it will never outperform it.
Things to know before investing in index funds
expense ratio In case of an active fund, the fund managers are assigned multiple functions. First, they should build a portfolio according to the fund’s theme and then monitor and intervene to ensure that investors are getting the best results. Naturally, this comes with a cost. Typically, this is charged to investors through a small fee known as the expense ratio.
But in the case of index funds, since no active management is required, the expense ratio is reduced. This means that index fund investors can get higher returns because only a minute portion of it is spent on fees.
It may work better for long term investment.
If you are investing for a short period, you may face losses. However, as per the historical data, these short-term bears get offset by the long-term returns. The above mentioned growth in Sensex and Nifty can be considered as an example.
Index funds can be ideal for corpus building if the factors mentioned earlier match your investment goals and risk appetite. Also, it is important to note that stock markets can be highly unpredictable, and historical data may not always be an indication of future results. Therefore, it becomes extremely important to assess how much risk you can take. Investment planning can be very easy if you have a clear idea of ​​your risk appetite.
Mutual fund investments are subject to market risks, read all the documents related to the scheme carefully.