Posted on 12/10/2022 11:58:00 AM

Diversification is the key to a sound investment portfolio. It aims to protect your portfolio from an adverse performance by a particular asset class, helping your portfolio stay sound. As an investor, you can try to disseminate your funds throughout asset classes like debt, equity, real estate, gold, etc. Also, within every asset class, you may try to diversify more to lower the risks. An index fund is an investment vehicle you can use to achieve this goal.

Read on to know index funds' meaning, benefits, different types, and how to invest in them.

What is an index fund?

Index funds are portfolios of bonds or stocks imitating the performance of the financial market index. Such funds replicate a portion of the stock market and, at times, the market itself. The funds are managed passively, which means your fund manager may park funds in the same list of securities as in the underlying fund index. They do not change the composition of the portfolio. Index funds track the performance of the underlying index.

How does an index fund function?

It is vital to remember that index funds track specific indices and are not managed actively, which is why they incur low expenses. As they follow the market index, they may not outperform the market. They assist in balancing the market-linked risks in your portfolio.

Let us understand this using an example. If an index fund tracks the NIFTY50 index, the fund portfolio will contain 50 stocks that constitute NIFTY50 Index in the same proportions. The index's portfolio will sometimes imitate the underlying index, even in percentage holding. Owing to such correlation, the index fund's Net Asset Value (NAV) may move with the index it is tracking.

Well-performing index mutual funds often aim to generate the same returns as their underlying benchmark. But even if index funds mirror the market movements, returns can be slightly lower than the index it is tracking.

This is owing to the variation called 'tracking error'. Outflows and inflows in the fund, corporate actions, changes in the index constituents, and cash levels in the fund affect tracking errors. Thus, when zeroing on the index mutual fund, it is best to ensure that its tracking error is minimal.

Index funds’ benefits

• Low fees

As an index mutual fund imitates its underlying benchmark, there's zero need for research analysts to assist fund managers in selecting the correct stocks. Also, there's zero active stock trading. All such parameters result in low managing costs of index mutual funds.

• No bias investing

Index mutual funds follow a regulation-based and automated investment method. The fund manager is given a defined mandate of the amount that must be invested in the index funds of different securities. It eliminates any bias or discretion while making investment decisions.

• Simple to manage

Fund managers do not need to worry about how the stocks on the index are performing, making index mutual funds easy to manage. A fund manager must only rebalance the fund portfolio periodically as per the timeline prescribed by SEBI from time to time.

Types of index funds

• Broad market index funds: Broad market index funds capture a large segment of the investible stock. It is well suited for you if you want to opt for a basket with a distinct variety of bonds or shares.

• International index funds: International index funds offer global exposure. They are not restricted to any stock market or country, providing you exposure to global/international companies in frontier or emerging markets.

• Market capitalisation funds: If you have a long-term investment timeframe, you can benefit by investing in market capitalisation funds. They endow increased exposure to a wide basket of Large, mid and small-sized companies.

• Bond-based index funds: Bond-based index funds can assist you in maintaining a balance combination of long, medium and short-term bond maturities, which yields steady revenues.

• Earning-based index funds: These index funds work based on the earnings or profits of a company. There are two kinds of company indices – value index and growth index. The value index contains stocks that trade at a lower cost than the company's earnings. Growth indices contain businesses that are anticipated to generate quick profits than the rest in the market.

How to invest in index funds?

For investing in index funds, you must follow the below stepwise process:

• Sign in through a secure app or website to invest in a mutual fund

• Finish the KYC process

• Post KYC process completion, select the index fund of your preference based on your financial objectives and risk appetite

• Once you have selected the index funds to invest in, transfer the appropriate amount into the funds

Index mutual funds could be an excellent way to start investing if you are new to market investing. They are cost-effective and attract minimum effort. Less volatility and predictable results in index funds also serve as an added advantage if you are a risk-averse investor.

Mutual fund investments are subject to market risks, read all scheme related documents carefully.

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