Passive is popular these days. What exactly are index funds and how do they meet your investment needs?

How does an index fund work?

It is a passively managed fund that invests in certain, stock or debt, indices and in all its constituents, stock or debt papers. The proportion is the same as that of the index. 

Exchange-traded funds (ETFs) also mimic indices but unlike index funds, they are traded in the stock market and can be bought on a real-time basis. Some funds use ETFs as their primary investments.

Now, the next question is whether index funds need to be part of one’s investment portfolio?

Is it a good entry point for First-time equity investors?

Index funds can be a good investment avenue for first-time equity investors. The equity market is volatile over the short term and index funds are a simple way to get familiarized with it through a small exposure.

Also, it is relatively easier to make choices. Once investors understand the nature of equity, they can gradually start with actively managed funds with their greater potential.

Can it help with diversification?

Existing mutual fund investors can consider investing a portion of their monthly SIP in large-cap index funds as a means of diversification. Why so?

Globally, large-cap equity funds have been finding it difficult to outperform their benchmark market indices, net of costs. In the past few years, it has been seen in the Indian context, as well. Four out of the top 10 return givers (five-year) among large-cap equity funds were index funds. While this is not a long enough duration to judge equity-based instruments in India, it’s still something to note.

Gold ETFs and international index funds can also be a good way to build a satellite portfolio without worrying about the performance of specific funds. 

How to add index funds to your portfolio?

For a Goal-oriented investment plan

What goal are you targeting and what’s the time frame – this will largely determine how much you need to invest and in what proportion. So, for instance, if your portfolio needs 10% annual returns to reach a target, then it might need at least 50% exposure to equity and so on. 

After deciding the asset allocation, focus on the sub-assets – the proportion to be invested into large-cap, mid-cap equity funds for equities and so on.

You can consider diversifying a portion of your large-cap equity allocation into large-cap index funds for the above-mentioned reasons. In mid-cap funds, so far, actively managed funds have outperformed their benchmarks and thus they seem to make more sense. 

However, while investing in international index funds, ensure you fully understand their nature and stick to reliable ones with a history behind them. For instance, S&P 500 is a diversified index of listed stocks in the US, while Nasdaq 100 or NYSE FANG+ is a concentrated set of technology stocks. 

Keep in mind the tracking error

Tracking error can happen due to expense ratios, illiquidity in certain securities (that increase cost due to higher bid-ask spread) or high market volatility. So, look for an index fund that is not only low on expenses but also closely resembles the market performance.

Go for ETF or Traditional index?

The expense ratio of index or ETFs is lower than most actively managed equity funds. ETFs in turn are cheaper than index funds. However, in India, due to low liquidity at the ETF counters, overall costs for investors could be higher. Moreover, if you are buying ETFs directly from the stock market, you need to have a trading and de-mat account. 

For most investors, an index fund makes more sense than ETFs. However, this might not be the case for popular international ETFs, which have significant liquidity. 

Takeaway

Consider expenses, tracking error and nature of the index before investing. A mix of active and passive fund portfolio in the large-cap equity space might be an effective investment strategy depending on your financial objectives.

Index funds can play a great role in a capital protection focused portfolio. Here's how Scripbox uses Index funds as part of a solution that solves the need for capital protection.