If research on ‘What is a mutual fund?’ and ‘What are the types of mutual funds?’, you will come across various mutual funds with different risk-return profiles.
Further, if you study the ‘riskometer’, you will observe that high-return mutual funds are high risk and investing in them involves a good deal of study. However, index mutual funds are types of equity funds that do not require intensive research or tracking. They are high-return mutual funds that give handsome long-term returns but are comparatively less risky than other equity-based mutual funds. Wouldn’t it be good to include these funds in your portfolio?
As the name suggests, Index funds are mutual funds that track benchmark indices, like the SENSEX and Nifty50. Their returns mirror the growth of the index. These funds are easy to understand since they simply follow their chosen index.
Here’s are a few detailed reasons why you should have Index funds in your mutual fund portfolio:
- Automatic diversification
Benchmark indices are a combination of top performing companies across various sectors of the Indian economy. Companies included in these indices are top performing blue-chip companies. For example, the SENSEX consists of IT companies like TCS and Infosys along with automobile manufacturing companies like Maruti. It also contains large-cap banking sector stocks. Therefore, even if one of the sectors underperform, there are other sectors to pull the index upwards. Since an index is a combination of various sectors, your index fund investment gets automatically diversified.
The minimum amount you can invest in a SIP (Systematic Investment Plan) is Rs.500. Therefore, with this amount in Index funds, you can diversify even with minimal investments. Diversification can also help reduce risk. This makes index funds more stable than other equity fund investments.
- Low Expense ratio
Index funds track only benchmark indices. These investments involve a minimal amount of research, and hence are passive in nature. Maintenance fees for passive funds are considerably lower than other equity funds, like ETFs (Exchange Traded Funds), ELSS (Equity Linked Savings Scheme), etc.
An actively managed diversified equity fund comes with a high expense ratio. This is because, these funds require active stock selection, typically tracking, and timely review. However, in index funds, all these aspects are absent. Therefore, these funds typically have an expense ratio of around 1%. A low expense ratio reflects in the fund’s returns, thus making these funds affordable.
- Tracking error
A benchmark index moves forward in the long-run. Although index funds merely reflect the movement of indices, sometimes your fund’s performance may deviate from the index movements.
A tracking error is a metric used to quantify the extent to which the fund’s performance has deviated from the indices. A low tracking error could indicate better performance of the index fund. If you need detailed information regarding it, you could seek the advice of a financial expert. However, here, you don’t have to worry about the short-term market fluctuations.
As compared to other equity-based mutual funds, tracking the performance of this fund is quite simple. However, these funds perform well from medium-term and long-term goals. Markets are volatile in the short-run; therefore, these funds are not suitable for your short-term goals. In the long-run, these funds perform well and offer handsome returns, since markets march forward. This makes it easier to track the performance of these funds.
With all the benefits mentioned above, index funds can be an effective portfolio enhancer. These funds can be excellent for new investors planning to begin their investment journey through mutual funds. If you are looking to invest in mutual funds, you may want to consider including index funds as a part of your portfolio.