Benefits of investing in Index funds

Much like most things under the sun, mutual funds have different types. They offer a diverse array of investment options, each classified based on various factors, including management style. As such, there are two types of mutual funds – actively managed and passively managed. Passive funds can further be classified into Exchange-Traded Funds (ETFs) or index funds. In this article, we will explore index funds and the benefits of index funds that you can enjoy.

What are index funds?

Index funds are mutual funds that track and replicate the performance of a particular index, such as Nifty or Sensex. Such funds have the same stocks in their portfolio as their underlying index and in the same proportion. For example, the NIFTY 100 index fund will invest in the same 100 companies that constitute NIFTY 100. Instead of trying to outperform the benchmark, index funds aim to generate returns in line with the benchmark.

Fund managers have a limited role to play in the case of index funds because of the passive nature of the fund. They do not buy and sell securities actively. Instead, they follow what the benchmark does. That said, it is the duty of fund managers to keep tracking the underlying index for any changes over time. They must rebalance the portfolio to match the changed composition of the index.

Now that you know how an index fund works, let’s move on to the benefits of an index fund.

Benefits of investing in index funds

1. Low cost: Index funds have low management costs because of the absence of active involvement of fund managers. These professionals need not research and trade actively. The mere mirroring of the performance of the underlying index limits the trading cost. Such funds have lower expense ratios as compared to other funds.

2. Diversification: Diversification is an effective way of minimising investment risks since not all securities perform in the same manner. The portfolio of index funds constitutes different securities that are present in their underlying index. These securities may be spread across market capitalisations, sectors, etc. Hence, you get to enjoy diversification with a single investment.

3. No human error or bias: Fund managers play an important role in the performance of the fund. They use their expertise, knowledge, and experience to maximise returns. However, with index funds, managers have a pre-defined mandate to follow with regard to the amount and weightage of securities in the portfolio. This eliminates the possibility of human discretion or bias while making investment decisions.

4. Liquidity: Index funds are open-ended mutual funds. Thus, you can withdraw your investment anytime and enjoy high liquidity.

5. Ideal for beginners: Being relatively low-cost investments that do not demand much time, skills and knowledge, index funds may be ideal for new investors, especially those to want to tap into the potential of equity funds.

To sum it up

Index funds follow a passive investment strategy. They simply aim to mimic the performance of the index they follow. As such, they become low-cost investments suitable for beginners and those seeking diversification.

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