Let’s get down to basics first:
What are index funds?
Index funds are a form of passive investment that seeks to mimic the portfolio of their benchmark index and are constructed to trace the components and return of that specific market index. As a result, Index Funds offer broad market exposure, relatively low operating expenses, and low portfolio turnover ratio.
How do Index Funds work?
The fund manager builds a portfolio that reflects the securities of a particular index. The idea behind this is the mimicking that leads to an overall similarity in the performance in the index. These indexes must change with the changes in the benchmarks; therefore, the weighted index requires periodical revaluation of the portfolio with respect to the presence in the benchmark index.
How is it different from actively managed funds?
Index funds are highly diversified. Its functioning and mechanisms are rooted in passive fund management. Passive management essentially means infrequent buying and selling of securities to maximize returns over the longer run. This passiveness differentiates it from actively managed funds by fund managers, including rampant stockpiling and timing the market.
What are the positives of the index funds?
The relatively low expense ratio has been the topmost advantage. Index Funds usually have an expense ratio of 0.5% or less compared to 1% to 2.5% for actively managed funds. That may soon increase since fund houses have raised the total expense ratio (TER) for index funds that track Nifty and Sensex . Nevertheless, this change will continue to keeps costs low as compared to actively managed funds. Another advantage lies in the broad diversification that Index Funds offer, making it relatively safer. The long-term returns are another pro of this instrument, making it ideal for passive investors looking for low-risk investment options.
What are the negatives of the index funds?
By mimicking a benchmark, Index Funds are far less affected by equity-related market risks and volatility. Although, Index Funds do lose their sheen during market downturns. On the returns side, since Index Funds track the performance of a benchmark, significant errors in tracking cab cause a mismatch which ultimately reflects in the returns being sub-par to that of the benchmark index. Further, there are limits to gains that can be rooted in the passive nature of such funds.
Investing for better results
The debate around actively managed funds versus passive management is relative. However, the low expense ratios involved lead to a better performance in general. Experts have noted that index funds have, in many instances, often outperformed the actively managed funds. It is imperative to understand that index funds do not aim to outperform the market but aim to match the risks and returns of the market.
However, your portfolio can not depend solely on Index Funds alone, opening your portfolio to concentration risks. A combination of passively managed funds with a blend of actively managed funds is more likely to offer your better long-term gains. To avoid a fund manager’s involvement in investing, investors choose Index funds; but, loss due to concentration risks could be far higher than that of actively managed funds.
Investors can expect strong returns from index funds, but their ability to consistently outperform active funds over time is dependent solely on the economy’s maturity and stock market performance.
To deep dive into Index Investing and its optimum allocation between passive and active investing, join us as we talk to an expert on Index Funds and ETFs, Mr. Pratik Oswal, in our next Masterclass series.
Register today: https://bit.ly/3xuTJjZ
Topic: Index Investing & Optimum Allocation: Active vs Passive
Expert: Pratik Oswal, Head – Passive Funds, Motilal Oswal Asset Management Company (ETFs + Index Funds)
Date: 02nd July 2021 @ 5:00 pm