What are index funds?

Index mutual funds imitate a stock market index such as NSE Nifty, BSE Sensex, etc. These mutual funds follow passive style of management. This means that the fund manager invests in similar securities that have similar proportions as in the underlying index it tracks.

What are the advantages of investing in index funds?

Following are some of the benefits of index funds:

  1. Low fees
    As index funds mimic its underlying index or benchmark, there’s no need for an efficient team of researchers and analysts to help fund managers pick the apt stocks. Also, there is no active trading of securities. All these parameters lead to low managing cost of an index fund.
  2. No bias investing
    Index funds follow an automatic, regulation-based investment style. The fund manager is provided with a defined instructionabout the amount to be invested in index funds of different securities. This eliminates human discretion/bias while making mutual fund investment
  3. Broad market exposure
    Investing money in a proportion similar to that of underlying index safeguards that the portfolio is diversified across all sectors and stocks. Thus, an investor can seize the likely returns on the greater segment of the market through a single unit of index fund. For instance, if you decide to invest in the Sensex index fund, you enjoy investment exposure to 30 stocks spread across various sectors, ranging from financial to pharma services.
  4. Tax advantages
    As index funds are passively managed funds, they usually enjoy low turnover ratio, i.e. only a few trades placed by a fund manager in a particular year. Fewer trades results in fewer capital gains that are passed to the shareholders.
  5. Easier to manage
    As fund managers don’t have to worry themselves with how a particular stock on the index is performing in the stock market, index funds are quite easier to manage. A fund manager just needs to rebalance the portfolio at periodic intervals.

Disadvantages of investing in index funds

Following are some of the disadvantages of investing in index mutual funds:

  1. Lack of flexibility
    As index funds are mandated to follow strategies and policies that require them to try to perform in lockstep with an underlying index, then enjoy comparatively lesser flexibility than managed funds.

  2. No significant returns
    Unlike managed funds, index funds do not carry the potential to outperform the market. This means that if you invest in index funds, an investor surrenders to the possibility of massive gains.

To summarise it, low cost, broad market exposure, easy management of the fund and getting the average index return are the advantages of investing in index funds, losing the opportunity of earning more than the index is its disadvantage.

Index funds are likely to save you a substantial amount of money and also lay a good foundation for your future financially. Owing to SEBI’s (Securities and Exchange Board of India) recent re-categorisation of mutual funds, several financial planners highly believe that index funds in India are likely to make their presence felt among numerous investment havens in the future. Happy investing!