Do you have Index Funds in your portfolio?

Active and passive mutual funds are the two main categories of mutual funds. Active Funds, as the name implies, are funds in which the fund manager actively manages the portfolio, buying and selling equities according to a customised investing plan. In Passive Funds, the portfolio is created as a replication of a certain index by the fund management. In other words, the portfolio tracks the index's movement. As a result, these funds are known as Index Funds.

Let's take a closer look at how they operate.

Active Funds:

The portfolio is constructed using a unique or customised investing strategy. According to the scheme's investing mandate, investments may be made in equities across market capitalization categories (in different weights), at times with a focused approach to specific securities, in various sectors/themes, and even other asset classes.

Passive Funds:

The fund manager tries to duplicate a certain index, such as the S&P BSE Sensex or the NSE Nifty 50. (by holding similar weights to the securities of the respective underlying index). According to regulatory standards, an Index Fund must invest at least 95% of its total assets in securities of a certain index (which the scheme replicates/tracks). There are a variety of Index Funds that replicate various indices such as the Nifty 50, Nifty 50 Equal Weight, Nifty Next 50, Nifty 100, Nifty 500, Nifty Midcap 150, Nifty Smallcap 250, Nifty Bank Index, S&P BSE Sensex, S&P BSE Bankex, and so on, in addition to large-cap indices like the Nifty 50 and the S&P BSE Sensex. Foreign indices are also replicated by certain Index Funds.

It's important to remember that the performance of the underlying index will determine your investing success. All the fund manager needs to do is make sure that the weights of the securities in the portfolio match those of the underlying benchmark index. As a result, an Index Fund almost never outperforms or underperforms its benchmark index. If it does, it is generally by a very little margin, and it is due to tracking mistake.

Index Funds provide for both lump sum and systematic investment plan (SIP) transactions.

Why should you put your money in index funds?

The following are some of the most important advantages of investing in Index Funds:

(1) Easy to comprehend and understand

Index funds are straightforward to comprehend and manage. If you're a beginner investor who's having trouble picking the correct fund among the number of active funds available, try investing in an Index Fund. Because they mimic the index, there's a case to be made for using Index Funds as a buffer alongside actively managed funds in your investing portfolio.

(2) Less risky than active funds

Index Funds have a relatively low portfolio turnover compared to actively managed funds, and so have a lower risk than Active Funds. Your returns will always be similar to the returns generated by your Index Fund's underlying benchmark index. An investor with a 3-5 year investment horizon who wants to diversify his portfolio might consider investing in an index fund.

(3) In comparison to active funds, it is less expensive.

Index Funds typically have an expense ratio of less than 1% (about 0.8%), which is far lower than actively managed stock funds, which can have expense ratios well beyond 1.5 percent. The performance of Index Funds over the previous year, as well as over three and five years, has been quite outstanding, justifying the cost ratio charged. In contrast, a large number of actively managed equity-oriented mutual fund schemes across sub-categories have struggled to surpass their respective benchmark amid the previous year since March 2020 in a polarised market upswing, and have been unable to justify the high cost ratio paid. As a result, you should think about incorporating some Index Funds in your financial portfolio.

Conditions to be aware of

• Index Funds, unlike Active Funds, are never able to outperform the benchmark. As a result, if the benchmark performs well, they will perform well as well. However, if the benchmark performs poorly, your returns may suffer as well.

• When comparing the performance of one Index Fund to that of others, make sure you know what the scheme's investing mandate is and what its benchmark is. You should strive to learn about the underlying index that the fund will monitor, as well as the index's members and the investing goal that the fund aims to attain.

• Find out what the tracking error is for your Index Fund. The standard deviation percentage difference, or the difference in the returns provided by the Index Fund and its benchmark, is referred to as tracking error. The cash maintained by an Index Fund to address redemption demands, as well as the input and outflow from the fund, and the weight given to each security of a specific index, all impact the tracking inaccuracy of the fund.

• Real-time transactions are not feasible since Index Funds are not traded on the exchange. By visiting the fund house or its registrars at the day-end Net Asset Value (NAV) stated by the fund house, transactions are completed.

In industrialised markets, notably the United States, index funds are extremely popular. Investors in India are beginning to recognise the value of Index Funds in their portfolios. As a result, Index Funds have seen significant inflows over the past year.