Investing in index mutual funds and ETFs receives a lot of great attention, and for a good reason. At their finest, index funds provide investors with a low-cost way to track major stock and bond market indices. Index funds surpass the majority of actively managed mutual funds in many circumstances.
Investing in index products may appear to be a no-brainer, a slam-dunk. In reaction to the popularity of index investing, mutual fund and exchange-traded fund (ETF) providers have introduced many new index products, which comes as no surprise.
To comprehend index funds, you must first grasp the distinction between active and passive investment. Consider yourself the manager of a diversified equity fund. This is an example of a fund manager who is active in the market.
The fund manager must decide which stocks to acquire, hold for the long run, trade for the short term, and sell. An active fund manager considers the stocks themselves and how they fit together as a portfolio. A varied portfolio in terms of sectoral and thematic exposures is required for a diversified equity fund.
6 reasons to choose index funds
The most transparent advantage of index funds is that they quickly diversify your portfolio, reducing the risk of losing some or all of your money.
Take a look at an index fund that tracks the S&P 500. About 500 different equities would be held in this index fund. While the performance of all of these 500 stocks varies over time, investing in a fund that owns them all aligns your portfolio with the index’s performance. By diversifying your portfolio across so many companies rather than investing in just one index fund, you may ensure that the worth of your portfolio is not unduly associated with the fortunes of just one of the index’s companies.
If you have the patience to hold on with discipline, index funds can offer substantial returns over a longer time horizon. The Sensex began trading at 100 in 1979 and has returned 36 times in the last 39 years. The NSE Nifty index was founded in 1995 and has returned 11-fold during the previous 23 years. What this means is that even a Nifty or Sensex index fund would have made good returns throughout the years.
Lower Turnover Ratio
The turnover ratio indicates how much of a fund’s holdings are replaced in a given year. For example, if you buy index funds in 100 equities and swaps out 10 of them this year, the turnover ratio is 10%.
By their very nature, index funds have a lower turnover rate than actively managed funds. The turnover ratios of index funds are typically about 1% to 2% each year, compared to 20% or greater for some actively managed mutual funds.
The difference between the final sale price and the initial purchase price is a capital gain when a fund sells a share for a profit. Capital gains are accrued more frequently in funds with greater turnover percentages, resulting in more taxes from the fund’s investors.
On the other hand, index funds are less concerned about this because of their low turnover ratios. There aren’t many capital gains to pass on to shareholders because fund managers don’t sell stocks all the time.
Easier to manage
Index funds are easier to manage since fund managers don’t have to worry about how the index’s stocks perform in the market. All a fund manager has to do is rebalance the portfolio regularly.
No Bias Investing
Index funds invest in a way that is automated and regulated. A stated mandate of the amount to also be invested in index funds of the investment portfolio is given to the fund manager. This removes human judgment and bias from investment decisions.
Investing in index mutual funds and exchange-traded funds (ETFs) can be a low-cost solution for all or part of your portfolio. Like any other investment technique, investing in index funds necessitates a thorough understanding of what you’re getting into. Investors must look beyond the “index fund” label to verify they are engaging in a low-cost product that tracks an appropriate benchmark for their investment strategy.