What are Index funds and should you invest in them?

Index funds have grown in popularity nowadays, as a growing number of investors have adopted passive investing strategies which attract low fees relative to active investment. In this article, we will try to understand what are Index funds and what things we should keep in mind while investing in them.

What are Index funds?

An index fund is an investment product that aims to match or we can say replicate the performance of an index for example the Standard & Poor’s 500 Index, better known as the S&P 500, the Dow Jones Industrial Average (DJIA), Nifty 50, Nifty 100, S&P BSE Sensex. 

SEBI insists that 95% of the entire assets should be in such replicating investment for index funds.

Index schemes are also referred to as “unmanaged schemes”, since they're passive, or “tracker schemes” since they follow a selected index. Passive investment needs less effort and time of the AMC. All that's required may be a good system that might integrate the whole process of valuation, generation of buy or sell orders. Management fees hence expense ratio for index funds are less than of managed or active schemes.

The replicating position in an index fund is created through either of two methods:

1. It can either be done by maintaining an investment portfolio that replicates the composition of the chosen index. Thus, the stocks in such a fund’s portfolio would be the same as those that are utilized in calculating the index. The proportion of every stock within the portfolio, too, would be the same as the weight of the stock within the calculation of that index.
2. This replicating of investment is named 'passive investing'. Index funds are therefore often called “passive funds”. Funds that aren't passive, on the contrary often called “managed funds”, or “active funds”

Working of an index fund

"Indexing" is a sort of passive fund management. The fund manager builds a portfolio (A basket of securities and/or derivatives) whose holdings mirror the securities of a specific index rather than actively stock picking and market timing i.e. choosing securities to take a position in and strategizing when to buy and sell them. Schemes that invest in such baskets are often viewed as “active index funds”. The thought is that by replicating the profile of the index, the stock market as an entire, or a broad segment of it & the fund will match its performance also.

Advantages

• Low expense ratios
• A good option for Diversification
• Ideal investment option for passive investors who believe in buy and hold.
• Better long-term returns

Disadvantages

• Vulnerable to market fluctuations & crashes
• Less human interference
• Lack of flexibility
• Limited Returns

Should you Invest in Index Funds?

Before you think to invest in index funds, it's important to check your investment horizon, assess your risk appetite, your pre-decided investing strategies. Below are some main points on which you can revolve your thinking regarding Index Fund.

Lower Costs

One primary advantage that index funds have over their actively managed equivalents is that the lower expense ratio. A fund's expense ratio also referred to as the management expense ratio includes all of the operating expenses like the salary to advisors, analysts, and managers, transaction fees, taxes, and accounting fees.

Index funds do not need the services of research analysts and other such resources that assist in the stock-selection process since the Index fund managers are simply mimicking the performance of a benchmark index. Managers of index funds trade holdings less often hence fewer transaction fees and commissions. In contrast, actively managed funds have more staff do more transactions, driving up the cost of operation.

Risk & Diversification

If you are someone who has a conservative or moderate risk appetite and would like to play it safe, then index funds are the proper fit for you. You can invest in an index fund even you have a higher risk appetite and want to diversify your portfolio. However, it's not good to invest in only index funds, especially when the market is at its peak. 

Returns

Returns from index funds are mostly the same as that of the market index. We should keep in mind that even low-risk investments can have low performance.

Since index funds reflect a part of the stock market or the market itself, the returns from these funds basically match the market’s performance.

Low Research

It is important to accept the amount of time you can spare to study, research, invest and monitor. researching, and maintaining so far with the market. If you’re someone who wants to stay investing with a predictable rate of return and less amount of hassle, then index funds are fit for you.

Generally, actively managed funds are better for more experienced investors or those that can dedicate the time to study investment strategies. If you’re someone who wants to outperform the market, comfortable with volatility & taking over a substantial amount of risk, then actively managed funds are more appropriate for you. Active funds are handled by a fund manager who has such resources to make informed decisions about different investment scenarios, predictions on performance, assess risk, and accordingly make changes to your portfolio.

Investment Time Horizon

Index funds perform better for the long term such as a minimum of 5-10 years. This enables you to get maximum returns as per the market index. The long-term nature of the investment must be taken into consideration before investing to ascertain if this matches your financial and investment goals.

For example, if you’re looking to get higher returns over a shorter period of your time, this won't be a good investment option for you.

Conclusion

Index funds are an excellent option to invest in the stock market if you’re new to investing, especially due to the low cost and efforts involved. Predictable results and less volatility will benefit you if you're unwilling to high-risk investing. Invest in Index funds assessing the compatibility with your financial goals & investment horizon.