Diversification is important to be a good investor, so people buy mutual funds and start investing, but it also has some risks. Now, to decrease the equity market risk. Investors start looking for Index Funds. Here we will talk about Index Funds along with their benefits and a lot more.
What Are Index Funds?
There are various types of mutual funds available in the market, one of the specialized types of funds is Index Funds. It is a type of mutual fund which tracks the financial market index, for example, Nifty 50, S&P 500, etc. These funds have a low expense ratio, they have broader market exposure. The index is used to measure different parameters such as interest rates, and inflations also it is used to establish benchmarks to compare with other mutual funds. In these funds, the fund manager invests money in the companies that are present in the index of the market, as the funds manager invests only in the companies of the index, sometimes these funds do not make an equal return as of index, due to tracking error.
How Do Index Funds Work?
Index funds work in a very simple way for example when you invest money in any index fund, then that cash is collected and used for investment in various other companies which eventually make a particular index. Thus providing you with different portfolios if you want to buy individual stocks of any company.
What are Low Cost Index Funds?
Low-cost index funds are a kind of pooled investment that has an annual management fee or low expense ratio. So if you or someone want to minimize their investment cost then they can generate vastly superior returns with time as the money which is lost to the fees will no longer be compounding on the investment account.
Types of Index Funds
Broad Market Index Funds: These funds copy a large section of the stock market. Large market index funds have low expense ratios. These funds are tax-efficient and also popular among those who want a large variety of stocks and bonds.
Bond-Based Index Funds: These type of funds comprises short and long-term bond maturities for steady revenues. This combination helps in the diversification of the portfolio but also makes healthy returns. This type of investment is popular among investor who needs a steady income.
Market Capitalization Index Funds: Market Capitalization simply means the market value of the company. This market capitalization is based on the market cap. This type of fund is suitable for the investor having a long-term investment strategy. Due to higher exposure in the market, they give massive returns.
Earnings-based Index Funds: These types of index funds are linked to companies having a higher capacity to generate profit than others in the market and also those trading at a lower cost compared with the company’s earnings. In this type of fund loss-making, the chance is quite low.
International Index Funds: These funds are not limited to a particular country. It gives the investor exposure to the international market. It can be affected if a specific country’s economy is outperforming or underperforming.
Things You Should Consider as an Investor Before Investing in Index Funds?
Disadvantages of Index Funds:
- Underperformance- Index funds can underperform due to tracking errors, fees, or expenses.
- Lack of Flexibility- An index fund may be less flexible to meet the price deadlines in the securities.
- Cost of Investment- The index fund’s expense ratio is nearly 0, but it must be noted there are several mutual funds having higher expense ratios but generating huge returns.
- Investment period- These funds are suitable for higher-time investment. Index funds experience a lot of fluctuations in a short period.
Lastly, you will never beat the market as these funds are solely dependent to match the market performance.
Advantages of Index Funds:
- No Bias Investing- These funds follow an automated regulation. This removes the human bias while investing in different securities.
- Low Fees- There is no need for an efficient fund manager hence, it leads to a low managing cost of the index fund.
- Lower Taxes- These funds do not change their stock holding, which results in fewer taxable capital gains.
- Broad Exposure- With index funds, the investor can target a larger range of markets through a single fund.
- Security Risk- With index funds the investments are done in the basket of assets. Therefore, a single share cannot cause major damage to the indices.
Lastly, investors are requested to review the nature and term condition of the fund before participating in the scheme.
Active Mutual Funds Vs Index Funds Vs ETF
An Exchange-traded Fund (ETF) stands for the exchange-traded fund this is a type of asset or security that tracks an index sector or specific type of investment. For example, if you’re buying an ETF to trade stocks. One share of an ETF can contain hundreds or thousands of different assets such as publicly traded companies so you’re owning hundreds or thousands of stocks within your one ETF.
| Comparison Basis | Active Mutual Funds | Index Funds | ETFs |
|---|---|---|---|
| Expense Ratio(management fees) | High | Medium | Low |
| Demat Account | No Demat account required | No Demat account required | Yes Demat account required |
| Liquidity | It has high liquidity as more number of investors | It has high liquidity as more number of investors | It has Low liquidity as Less number of investors |
| Effort | Efforts are required to manage the fund | Not much effort is required to manage the fund | Efforts are required to understand the pricing |