What Is Index Fund And Who Should Invest In Them?

It's all about a $1 million bet – Can hedge funds outdo index funds in a decade?

With a net worth of $116 billion, Warren Buffet is considered a legendary investor. So, when in 2007, he made a $1 million bet with Protégé Partners that hedge funds wouldn't be able to outperform index-tied funds, you'd know he was onto something. And it turns out he was right!

The investing icon has reiterated the need to invest in index funds time and again. According to him, low-cost index-tied funds are one of the smartest investment decisions a person can make. And thanks to his words of wisdom, index funds have now become the talk of the town.

2020 saw a staggering 144% increase in the number of index-tied funds, while the assets managed by them rose to a brilliant 590%. Undoubtedly, they are becoming one of the most sought-after investment options. And it is time you, too, enjoy the benefits of investing in index funds.

But what is index fund? Here's all you need to know about index fund investments.

What is index fund?

Also known as index-tracked or index tied mutual funds, these funds are a type of mutual funds that mimic an index's portfolio. It is a passive form of investment as its objective is to track the performance of a stock market index such as BSE Sensex, NSE Nifty, etc. Here, the asset allocation of the index-tied fund is the same as the underlying index.

Essentially, index-tracked funds don't endeavour to outperform the market; they simply try to follow an index. Hence, they tend to offer returns matching the index they track.

How do index fund investments work?

An index is a group of securities which defines a market sector. Equity-oriented instruments like stocks and bond market instruments are examples of these securities. Suppose an index-tied is tracking a benchmark such as the Nifty. Now, this index fund will have the same 50 stocks in its portfolio that comprise Nifty in the same proportion.

Based on the composition of the underlying benchmark (Nifty in this case), the fund manager decides which stocks are to be bought and sold. Moreover, these funds typically deliver returns that are more or less equal to the benchmark, as they strive to match the benchmark’s performance.

Who should invest in index-tied funds?

Now that you know what index fund is, the decision to invest solely depends on your financial goals and risk tolerance. If you're a risk-averse investor looking for predictable returns and portfolio diversification, index fund investment makes sense for you. You can invest in a Nifty or Sensex index fund if you wish to become a stock investor without the risk associated with actively managed equities. And earn greater returns corresponding to the upside a particular index sees.

Factors to consider for index fund investments

There are several benefits of investing in index funds. When you buy an index-tied fund, you enjoy a diverse range of securities in a single low-cost investment. In fact, by investing in numerous index-tracked funds, you can build a diverse portfolio to match your investment goals and minimise your overall risk.

However, before investing, there are a few things you need to consider as an investor.

1. Returns

Unlike actively managed funds, index-tied funds do not aim to outperform their benchmark but rather just imitate the index's performance. As a result, there might be a difference between the index and the fund performance (called tracking error). Ideally, you should shortlist funds with minimum tracking error – the minimum the error, the better will be the performance of the fund.

2. Risk factor

Because they are passively managed, they are less volatile. If you wish to generate better returns during a rallying market, index-tied funds are your best bet.

3. Expense ratio

The expense ratio is a percentage of the total assets charged by the fund houses as fees for fund management services. One of the most significant benefits of investing in index funds is its low expense. As they are passively managed, the fund manager does not need to formulate any investment strategy. This reduces the cost of investment and a lower expense ratio.

4. Investment goals

Typically, index-tied funds are suitable for individuals with a long investment horizon. These funds tend to experience fluctuations in the long term, which usually averages over the long run. So, if you have an investment window of over seven years, you can expect the fund to perform to its full potential.

Over to you

In a nutshell, index-tied mutual funds perform well over the long term, offering you higher returns at minimum risks. Being less volatile, they are excellent means to enrich your investment portfolio.

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