What is an Index Fund and how it beats 95% market?

If you think that Real Estate is good investment and looking for other things that may serve you the same purpose then today’s post if for you. Index Funds can be best investment in long run and may provide you with better results than actively managed funds. So sit back and read the full post and don’t forget to give us your suggestions.

So lets start with basic What is an Index Fund ?

What is an Index Fund?

Diversification is one of the characteristics of the Index Funds, now as the article goes you will learn What is Index Fund and how it so efficient that even beats 95% of the market.

An Index Fund invests in a stock that is an imitation of a stock market index like BSE Sensex, NSE Nifty, etc. The fund manager invests in the same securities as present in the underlying index in the same proportion and doesn’t change the portfolio composition.

In other words, An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index. Index funds have lower expenses and fees than actively managed funds. Index funds follow a passive investment strategy.

You can watch John Bogle’s detailed video, in this video he explained in depth about Index Fund and how it works.

How Index Fund works?

Mostly Index Fund have lower expenses and fees than actively managed fund and follows a passive investment strategy.

Index Fund seeks to match the risk and return of the market on the theory that in long term, the market will outperform any single investment. Above was some deep theory about Index Fund, but sticking to the topic. Here how Index Funds actually work?

Each stock has certain weight in the market index and even Index Fund give the same weight to the particular stock in the fund.

For Example. You went to a grocery store and find there are a lot of vegetables like cabbage, potatoes, tomatoes and they are very expensive individually. On the other hand, the store offers a basket which contains some cabbage, tomatoes, potatoes and it is less expensive when you were to buy them individually.

Accordingly Index Fund works pretty much in a same way.

What is an Index fund?
expense ratio

By now you should understand that there is no effort being put to select the investment stock for an Index Fund.

Also, Index Fund act as small market or mimic the market and hence they have low expense as compared to actively managed funds.

If you like above explaination, I learnt this from Graham Stephan. You can watch that video through following. He explained really well about What is an Index Fund and some other concepts related to it.

A major difference between Index Funds and Actively Managed Funds

On average an actively managed fund charge a fee of around 2% which may vary from the type and size of the fund.

Index Funds and Actively Managed Funds

At the same time, the Index Fund charges as low as 1% from its investors. This helps retail investors as they are paying less expense ratio as compared to actively managed funds.

Who should invest in Index Funds?

The investment decision in a mutual fund solely depends upon your risk preferences and investment goals. Index fund are ideal for investors who are risk-averse and expect predictable returns. These fund do not require extensive tracking.

For example, if you wish to participate in equities but don’t wish to take risks associated with actively-managed equity funds, you can choose a Sensex or Nifty index fund. These fund will give you returns matching the upside that the particular index sees. However, if you wish to earn market-beating returns, then you can opt for actively-managed funds.

Who should invest in Index Funds?
Who should invest in Index Funds?

The returns of index fund may match the returns of actively-managed fund in the short run. However, the actively-managed fund tends to perform better in the long term.

for this reason, if your goal is long term and you don’t want to look at financial statements daily and don’t want sleepless nights.

You want to invest and forget and let your let investment bring juice for you, then Index Fund is your way to go.

What are the advantages of Index Funds?

Here are some of the pros of having index fundsin your investment portfolio:

A. Index funds are diversified

Like I mentioned earlier, index fund are a type of mutual fund. And like other mutual fund, index funds are usually filled with stocks from hundreds of different companies. That gives you a nice layer of diversity and you can check our post on the Financial market for a better understanding of market.

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Advantages of Index Funds.
Advantages of Index Funds

B. Index funds have lower expense ratios. 

Because index funds are basically just copying the index they’re named after, there’s not much to manage. Because of that, index funds usually have lower fees and expense ratios.
 

C. Index funds are predictable

What you see is what you get. With an index fund, you know you’re going to get returns that are more or less the same as the stock market. And just like the stock market, there are going to be ups and downs

Things to keep in mind before investing

Risk Appetite

Since index funds map an index, they are less prone to equity-related volatility and risks. Investing in index fund is an excellent option if you wish to generate high returns amid a rallying market. However, you will have to switch to actively-managed funds during a market slump. Index fundstend to lose their value during a market downturn. Hence, it is advised to have a mix of actively-managed funds and index funds in your portfolio.

Return factor

Unlike actively-managed funds, index funds track the performance of the underlying benchmark passively. These fund do not aim to beat the benchmark but just to replicate the performance of the index. However, the returns generated may not be at par with that of the index due to tracking errors. There can be deviations from actual index returns.

Hence, it is advised to shortlist fund with minimum tracking error before investing in an index fund. The lower the errors, the better the performance of the fund.

Things to keep in mind before investing
Things to keep in mind before investing

Cost of investment

Index funds usually have an expense ratio of 0.5% or even less. In comparison, actively-managed fund have an expense ratio of 1% to 2.5%. The portfolio of the index funds need not be passively managed, and the fund manager is not required to formulate any investment strategy. Hence, the difference in the expense ratio.

If two index funds are tracking the Nifty, both will generate similar returns. The only difference will be the expense ratio. The fund, which has a lower expense ratio will generate comparatively higher returns on investment.

Investment horizon

Index fund, generally, suits individuals with a long-term investment horizon. Usually, the fund experiences many fluctuations during the short-run, which averages out in the long-run, say, more than seven years to generate returns in the range of 10%-12%. Those who choose index funds must be patient enough to stick around for at least that long. Only then can the fund perform at its full potential.

Financial goals

Equity fund can be ideal for achieving long-term financial goals like wealth creation or retirement planning. Being a high risk-high return haven, these fund are capable of generating enough wealth, which may help you retire early and pursue your passion in life.

Tax on gains

When you redeem units of index funds, you earn capital gains, which are taxable. The rate of taxation depends on how long you stayed invested in index funds, i.e., the holding period.

Top 3 Index Funds to invest

Before going forward I want to give you a little advice that is very obvious but often gets neglected. As our only mission is to making Financial knowledge more understandable to our readers.

Read each and every statement very carefully when you are going to invest in index funds, in fact, you should do this with every single investment you make in the future. Index Funds are suitable for long term investors.

While selecting a fund, you need to analyze the fund from different angles. There are various quantitative and qualitative parameters to determine the best index fund as per your requirements. Additionally, it would be best if you keep your financial goals, risk appetite, and investment horizon in mind.
The following table represents the top 3 index funds in India, based on the past three-year returns. Investors may choose the funds based on a different investment horizon like 5 years or 10 years of returns. You may include other criteria like financial ratios as well.

TOP 3 INDEX FUNDS

CONCLUSION

Each stock has certain weight in the market index and even Index Fund give the same weight to the particular stock in the fund.

The investment decision in a mutual fund solely depends upon your risk preferences and investment goals. Index funds are ideal for investors who are risk-averse and expect predictable returns. These funds do not require extensive tracking.

Read each and every statement very carefully when you are going to invest in index funds, in fact, you should do this with every single investment you make in the future. Index Funds are suitable for long term investors.

So now we have come to end of our today’s post. Please give us your suggestions and feedback so that FinanceBread can offer you great service.

You can also read our post on Mutual Funds through here.

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