Index Mutual Funds: Everything you need to know before investing

We all know that to build a rewarding investment portfolio, diversification is essential. To diversify their portfolio, investors often consider various asset classes such as gold, debt, stocks, etc. However, they look forward to further diversifying within these asset classes to mitigate the overall investment risk. When it comes to equity mutual funds, the fund managers build the scheme portfolio by collating various credible stocks belonging to companies of various sectors and industries spread across market capitalizations.

Index mutual funds follow a similar investment strategy. Let us take a look at what index funds are, how they work, their features and benefits, and factors to consider before investing.

What are Index Mutual Funds?
An index mutual fund is an open-ended scheme that invests the majority of its investible corpus in underlying securities that comprise a benchmark, like the NIFTY 50 or the SENSEX 100. These funds invest a minimum of 95 percent of their total assets in the equity and equity related instruments of companies listed under a particular index, without changing the composition. Since these are passively managed funds, the portfolio manager ensures that the composition of the index funds remains aligned with that of the securities in the underlying index. Unlike other mutual funds that aim to outperform their benchmark, index funds aim at generating returns close to that of the underlying benchmark instead of outperforming.

Understanding how Index Mutual Funds work
Let us assume that a particular index fund is tracking CNX NIFTY (NIFTY 50) as its underlying benchmark. Such an index fund portfolio will comprise all the 50 stocks from the index in the same proportion as they are listed on the index. An index may comprise of equity and equity related instruments, or they may also comprise of fixed income securities. Such indexes are referred to as fixed income indices of bond indices. When it comes to active funds, the fund managers actively manage the fund’s portfolio and are the decision makers. They are there to ensure that the fund generates benchmark beating returns and returns that will outperform the competition. But in the case of passively managed funds like index funds, these do not try to outperform their underlying index. Instead, index funds follow a passive investment style and are designed to closely track their benchmark and generate similar returns. However, the returns generated by index funds are subject to tracking errors.

Index Mutual Funds are ideal for
When investing in mutual funds, investors must first identify the risks associated with the scheme, then determine if their risk appetite allows them to take such risks. Also, it is important to ensure that the investment objective of the scheme aligns with that of the investor. Index funds that comprise stocks as their underlying securities have very high investment risk. Investors may even take a look at the riskometer, to understand the volatility factor.
Investors who have a very high risk appetite and are willing to invest for the long term may consider adding index funds to their mutual fund portfolio. At times, investors are not comfortable with the fact that the returns generated by a mutual fund scheme are driven by human emotions.
They are not happy with the fact that the fund managers may change the portfolio composition without their knowledge, and they might end up investing in stocks that are volatile for their portfolios. That can’t happen with index funds as they only comprise stocks that are listed on the underlying index. If the composition of the stocks changes in the index change, the fund manager only rejigs to ensure that the portfolio matches the index composition to avoid tracking errors. Investors who are not keen on investing in mutual funds that try to outperform the benchmark and are alright with a scheme that tries to generate returns similar to its benchmark, may prefer index funds.

Things you should consider before investing in Index Mutual Funds
Before investing in index mutual funds, investors must ensure that they have a long-term investment horizon. To allow an equity linked scheme like an index fund to perform to its fullest potential, it is advisable for the investor to remain invested for the long run. Short-term investing in equity-oriented index funds may not be advisable as equity investments are constantly affected by fluctuations in the market and may even generate negative returns in the short run. To witness their investments grow and compound gradually, investors need to be patient and remain invested in index funds keeping a long term investment time horizon.

Since index funds are more likely to perform over the long term, investors can target their life’s long term financial goals with index funds. If wealth creation is on your mind, then index funds can give your portfolio the much needed push. One may even consider index funds for goals such as retirement planning. Index funds are known to have a high risk-return tradeoff. Although there is a very high investment risk, there is a possibility that the scheme may allow investors to earn some capital appreciation over the long haul.

As mentioned earlier, index funds are designed to map the performance of the index. This mostly omits biases, errors, or any investment risks that can be driven by human emotions. Index funds may allow investors to help them with their financial goals, but investors are expected to diversify their portfolio with other actively managed mutual funds as well. It may not be advisable to solely depend on index funds for achieving all financial goals. Striking the right balance between active and passive funds might help investors in building a rewarding portfolio.

Returns generated by index funds are based on the passive tracking style and are subject to tracking errors. The returns generated by an index fund may vary from that of the benchmark. If the index fund has many tracking errors, the actual returns are bound to deviate from that of the benchmark. Hence, it is advisable to consider index funds that have a low tracking error record. An index fund that is low on tracking errors might be able to generate returns close to its underlying benchmark.

When we talk about index mutual fund investments, it is impossible to exclude the expense ratio from the discussion. Unlike actively managed funds that have a considerably high expense ratio, index funds are considered to be a cost-effective investment. The returns generated by index funds are through a passive investment strategy. The fund manager need not devise an investment strategy for the fund to generate returns. Index funds track their underlying benchmark and try to generate similar returns. Since there isn’t much involvement from the management, index mutual funds attract a low expense ratio. Do understand that if there are two index funds tracking the same index as their benchmark, they are probably going to generate similar returns. Hence, in such a scenario an individual may consider the index fund with a lower expense ratio.

What are the different ways to invest in Index Mutual Funds?
Like most mutual fund schemes, an individual can invest in index mutual funds either by making a lump-sum investment or can consider opting for the Systematic Investment Plan. A lump-sum investment is something that the investor makes right at the beginning of the investment cycle. This is the entire investment sum that he or she wishes to invest in the index fund for potential capital appreciation. A lump-sum investment might be favored by those who have surplus capital sitting idle or for someone who has recently inherited money through their family or some old investment policy that is matured. It may also be favored by those who have seasonal revenues and those whose income is not regular. On the other hand, salaried individuals who have a regular monthly income source may consider taking the SIP route.

Also, referred to as the Systematic Investment Plan, SIP is probably the easiest and hassle-free way to invest in index funds. All an individual needs to do is complete all the pre-investment formalities, ensure that they are KYC compliant so that they can start their investment journey. Investing in index funds via SIP is a simple process. Investors need to decide a sum that they wish to invest at periodic intervals. SIPs come in various forms – weekly, monthly, quarterly, biannually, and annually. However, most individuals prefer the monthly SIP option as this way they save and invest a fixed sum every month. Once the individual decides the amount, fixes the SIP date, and automates transactions, every month of the fixed date the predetermined SIP sum is debited from the investor’s savings account and investors can buy units with the amount. The unit allotment takes place in quantum with the SIP sum and the current NAV (Net Asset Value) of the fund.

Here’s an example of how you can invest in an index fund via the Axis Mutual Fund website –

  • Log on to www.axismf.com
  • If you are visiting Axis Mutual Fund for the first time, create an account by clicking on the ‘New Investor’ icon
  • Then, hover on the ‘All Schemes’ tab and when you get a dropdown, click on ‘Equity’
  • Let us assume you wish to invest in ‘Axis Nifty 100 Index Fund Regular Growth’
  • Scroll and search for ‘Axis Nifty 100 Index Fund Regular Growth’ and click on the scheme
  • Click on the ‘Start A SIP’
  • Enter the SIP sum, SIP date, SIP tenure, and Plan (Growth/Dividend)

You have just made your first investment in an index mutual fund!
Before investing in any type of mutual fund scheme, investors must consult their financial advisor. They must be fully aware of all the risks that are associated with the investments they’re about to make. Also, it is essential to understand that the past returns of the mutual fund scheme may not be sustained in the future. Returns from mutual fund investments are subject to market risks and never guaranteed.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.

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