Of the many categories of mutual fund schemes available, index funds are considered less risky, extremely accessible, and cost effective. However, should you be investing in them? If you do intend to invest in them, which factors must you consider? Read on to know everything about the nature and functioning of index mutual funds.
What are index funds, and how do they work?
An index mutual fund tries to replicate the results of a portfolio of stocks belonging to a particular financial index. They can also replicate a section of the stock market or the market itself. You can track the performance of an index fund by analysing the performance of a specific group of assets in the market. For instance, if an index fund is tracking the NSE Nifty index, it will invest in all the securities that the index tracks. An index fund investment does not try to actively outperform its benchmark index but rather tries to match its returns.
Benefits of investing in index funds:
Here are the key benefits of investing in index funds:
- Index funds are cost effective: Generally, passively managed mutual fund schemes like index funds are less expensive than actively managed ones. Hence, if you invest money in an index fund, you generally end up spending less on fees.
- You can diversify your investment portfolio by investing in index funds: Index funds help you spread your investment across various asset classes such as stocks and bonds.
- Your holdings in an index fund are always accessible: A key advantage of index fund investments is transparency. You will always be able to access your index fund investments.
- Index funds help you leverage tax benefits: Since index funds don’t trade actively on the stock market, you can avail benefits like lesser long-term capital gains tax compared to other funds by investing in an Index fund.
- Index funds are ideal for first-time investors: Finally, index funds are ideal for any new investor who wishes to take low-to-moderate risk and earn consistent returns.
Factors you must consider before investing in an index fund
Here are the points that you must consider before investing in an index fund scheme:
- Avoid investing only in index funds: While index funds generally pose a low risk to the investor, it is not advisable to invest only in index funds. You must invest in a mix of passively managed funds like index funds and actively managed mutual funds like equity funds.
- Check the fund’s expense ratio: You must also check the expense ratio of an index fund before investing in it. Their expense ratios are generally lower when compared to other mutual fund categories.
- Note down your investment goals and invest accordingly: Most importantly, you must define an investment goal before investing in an index fund scheme. Depending on your goal, you can decide to slightly increase your investment amount over time. Remember that your investment goals change in nature over time. To keep up with the times, you must gradually increase your contributions towards index mutual funds.
Should you invest in an index fund scheme?
You should certainly invest in the best index funds to earn consistent returns if you fall in any of the following categories:
- You have a low-to-medium risk appetite: If you wish to play it safe with your index fund investment (i.e., if you have a low-risk appetite), you can consider investing in an index fund scheme.
- You wish to passively invest in the stock market: You should opt for index funds if you don’t wish to opt for actively managed mutual fund schemes.
- You don’t wish to invest too much time: If you don’t have a lot of time to track and manage your investments, you must consider investing in an index fund.
Before investing in an index mutual fund scheme, you should fix your investment objectives, use a returns calculator to calculate your index fund returns, and keep reassessing your investment to make any changes in it if required.
