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Investors try to spread their funds across various asset classes like equity, debt, real estate, gold, etc. Even within each asset class, they try to further diversify to minimize risks. Diversification is a key element of a good investment portfolio. In the long term, the journey of the market indices is upward. While the kinds of growth they have exhibited over the years are attractive to investors, one cannot directly buy an index because they are only mathematical constructs. Index funds give investors the opportunity to invest in the index.

To understand what index fund, you first need to understand “Index.”

In our daily lives, we must have come across news talking about how the stock markets have performed, how many points it went up or down, and the percentage change. But have you wondered where this number comes from? Is it a change in one stock, all the stocks or something else?

The two biggest stock exchanges in India-  The Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) has about 5,000 and 2,000 companies listed respectively, so it’s practically impossible for them to track the movement of each stock and then calculate the market movement. That’s where index comes into play. An index is a theoretical portfolio created in a way that it represents the overall financial market.

An index is created by first selecting the sectors and their weights and then picking companies from each of those sectors and assigning weights to each company. Which sector and what company gets chosen is basis multiple factors

For example - SENSEX is an index created by BSE and is a basket of 30 stocks from different industries. The change in the SENSEX comes from the change in the prices of these underlying stocks, and this change is used as representative of overall market movement.

Now the question is- what is an Index fund?    

Index funds are a kind of mutual fund that invests your money in the same companies and in the same proportion as the index it tracks.

How do index funds work?

In an index fund, firstly, a benchmark index is chosen. Thereafter, the fund manager copies the portfolio composition of the index and invests the fund corpus in the same securities held by the underlying index. The proportion of holding of each security also matches that of the tracked index.

For example, say an index fund uses Nifty 50 as its benchmark index. Nifty 50 contains stocks of 50 companies. The Nifty 50 index fund would also invest in the same stocks as the Nifty 50. Moreover, the weightage of each stock would also be in sync with the Nifty 50 index. For example, if RIL constitutes 9.7% of the Nifty, the Nifty 50 index fund would also have RIL comprising 9.7% of its total portfolio.

Should the composition or the weightage of securities in the index change during the bi-annual review, the fund manager would affect the same change in the fund to always retain the match with the underlying index. Thereafter, as the underlying index, the Nifty 50 in the aforementioned example, performs, the index fund also yields similar returns. 

Benefits of index funds
  • No Bias Investing- Index funds follow an automated, rule-based investment methodology. The fund manager has a defined mandate on where the money goes and how much he/she needs to follow. This removes the human bias/discretion while taking investment decisions.

  • Low Fees- Index funds replicate an index; therefore, there is no need for a team of analysts for research and helping fund manager find stocks. Even fund managers don’t need to put their expertise in portfolio construction. Moreover, there is no active buying and selling of stocks. All these factors make the expense of managing an index fund low, and this translates into low fees for investors.

  • Low cost of investment- An investor buying all the stocks in a benchmark index will require huge capital. However, through index funds, investors can own all the components of the index in the same weightage but at a fraction of the cost.

Limitations of index funds
  • Returns do not beat the index- Index funds aim to match the returns of the benchmark index. They do not outperform the benchmark index and generate alpha. Even when the markets are rallying and there is a scope to beat the benchmark, the returns of the index fund are limited. Therefore, this does not bode well with investors looking to earn maximum returns on their investments. 

Should we invest in Index Funds?

Warren Buffet, the legendary investor, recommends US investors should choose index funds for investing via mutual funds. Moreover, the biggest mutual fund in the world is an index fund and is trusted by millions of people.

And there is a good reason for that. The combination of all the advantages mentioned above really simplifies the entire investing process. You are sure to get almost the same returns as the market is generating at a low cost and without doing much,

However, before you jump to a conclusion, a word of caution. In the Indian context, if you look at the returns of good active funds over the 5 to 10-year duration, most of them have given 3–5% more returns(alpha) than the index. But this alpha is shrinking, especially in the large-cap space and will continue to go down.

So, the smart thing would be to begin by allocating 5–10% of your portfolio to this category.

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