Index Funds: Checkout The Pros And Cons

Situations Where SIPs Are Not Good For InvestmentOne of the most preferred investment schemes that Indians generally opt for is mutual fund plans. These funds are investment products in which an AMC first pools money from a group of investors. Once enough money is collected in the fund, it is used to purchase different securities. The securities that are usually the targets for an investment in mutual funds include assets like bonds, gold, stocks, and even money market instruments. However, it is important to note that just selecting a mutual fund scheme is not enough. You are also required to select the right type of mutual fund. One of the different variants of mutual funds is an index fund.

 

What are index funds?

Index mutual funds are the variant of a mutual fund scheme that is known for imitating the portfolio of a certain index. Because of this, they are also called index-tied or index-tracked mutual funds. These funds come with a goal. The said aim of these passively managed funds is to simultaneously track and match the performance of a popular stock market index. Prominent examples of popular stock market indices are the BSE Sensex and NSE NIFTY 50.

Under these funds, the style of asset allocation followed will be the same as that of its underlying index. This is why the revenue earned from index funds is comparable to that of their underlying index. In an index mutual fund, just like it is the case of mutual fund schemes, an investor’s money is pooled with that of other investors. Once enough money is accumulated in the fund, the portfolio manager allocates them to indices such as stocks and bonds. Even if the fund manager may or may not opt to invest in every component of an index, the main aim here is to get an appropriate sample of every piece. This action ensures that the index performance can be effectively tracked with time.

 

How do they work?

A cluster of securities that define a particular market segment is referred to as an index. As these funds trace the performance of a specific index, generally, they fall under the passive fund management category. In funds that are passively managed, traded securities are heavily dependent on the performance underlying benchmark. Furthermore, passively managed funds don’t require a team of research analysts to carefully analyze market movements and then pick the most-suited stock. Unlike actively managed funds, which are known for trying to time and beat the market, an index fund is designed in such a way that its performance matches that of its index. The returns on index funds are linked to the underlying market index.

 

What are its merits?

  • These schemes don’t burn a hole in the wallet:

As stated earlier, with index funds, there is no requirement for a team of research analysts that can help fund managers to pick the right stocks. Also, there is no active trading of stocks. These factors result in the low managing cost of an index fund. So, if you are looking for an option in which you don’t need to pay a huge fee, don’t look further than index funds.

 

  • Index funds can be managed easily:

This variant of mutual funds is also known for being easier to manage as you don’t need to worry about the performance of stocks on the index. All that’s required to do is for the fund manager to rebalance the portfolio periodically.

 

  • They are a stable investment option:

Index mutual funds are ideal if you are searching for a stable investment tool. A major alluring feature of these funds is that they do not require actions like extensive research and tracking. For example, you are looking to invest in equities. However, simultaneously, you don’t want to expose yourself to the risks associated with equity funds that are actively managed. So, you can go ahead and opt for a NIFTY or SENSEX index fund.

 

  • They are also known for providing broad market exposure:

By allocating funds in an index, you ensure that your investment is spread across all sectors and stocks. By doing so, an investor can earn income on the larger segment of the market through a single index fund. For instance, you decide to invest in the Nifty index fund. By doing so, you enjoy the investment exposure to stocks that are spread across different sectors. With index funds, you can invest in businesses of different sectors such as pharma and financial services.

 

What are its demerits?

While there are numerous benefits associated with index funds, there are demerits too. Listed below are some:

 

  • They are very flexible:

The discretion of the fund manager works better in the case of active funds when asset allocation decisions must be taken. For instance, if an equity fund manager finds the market volatile, then the fund allocation can be increased substantially. However, an index fund does not afford the same level of flexibility. Investors are required to be fully invested in the index all the time.

 

  • Index funds are vulnerable to tracking errors:

While index funds are free from the bias of the fund manager, they are still vulnerable to the risks associated with tracking errors. Tracking errors can occur in an index fund due to things like index constituent changes, corporate actions, and liquidity provisions. This is a major risk in index funds.