Of the many categories of mutual funds in India, index funds offer specific benefits to investors. They are affordable, help you diversify your portfolio, and replicate the performance of their benchmark indices. This guide takes you through the various benefits as well as the limitations of investing in index funds so that you can make an informed investment decision.
Benefits of investing in index funds:
Here are the key benefits of starting an index fund investment:
- You need not worry about any fund manager bias: If you invest, for instance, in an actively managed equity mutual fund, you might have to worry about the fund manager’s bias affecting your returns. In the case of index funds, however, you need not worry about such a bias. Since the stock selection in index funds is limited to companies chosen by the benchmark index, fund manager bias plays no role in any investment decision.
- Index fund investments are affordable: One of the most popular benefits of index funds is their affordability. Since the stock selection is done based on the benchmark index, the fund management team of an index mutual fund is generally smaller, thereby resulting in lower fund management fees. The expense ratios charged by index funds are generally lower when compared to other mutual fund categories since these are passively managed mutual funds.
- Index funds replicate the performance of their benchmark indices: Top index funds replicate the performance of their benchmark indices, thereby offering comparable returns within a margin of the scheme’s tracking error. If you remain invested in an index fund for a long term, there is a good chance of your investment generating long-term, sustainable returns.
- You can achieve portfolio diversification by investing in an index fund: You can also use index mutual fund investments to diversify your investment portfolio. If you choose an index fund based on a large-, mid-, or small-cap index, your investments will still be diversified, thereby mitigating overall risk. You can therefore use index funds to benefit from various sectors of the economy all at once.
- Index funds pose a lower concentration risk: By investing in index funds, you will also be avoiding a limited exposure to a specific stock. Index fund investments reduce the overall concentration risk of a portfolio. Indices such as NIFTY 50, NIFTY 100, or NIFTY SmallCap 250, for instance, are constructed in a way that they don’t offer limited exposure to specific stocks.
- These are professionally managed funds: Index funds are technically “passively managed funds”, however, they do have fund managers. These fund managers ensure that the allocation of investible assets is managed as prescribed by the scheme’s stated investment objectives.
Limitations of investing in index funds:
Here are some limitations of investing in an index fund:
- They have poor downside management: Most index funds in India are based on diversified equity indices that have no debt allocation. Hence, there is no downside protection, which makes these investments prone to significant volatility.
- The returns offered by an index fund investment have a limit: The term “alpha” is used to describe an investment strategy’s ability to beat the market. It is defined as the excess return or the abnormal rate of return in relation to a benchmark index. In the case of index fund investments, the value of alpha is very low, as these mutual funds simply aim to replicate the performance of the benchmark index. Hence, the overall returns generated by index funds has a limit.
In summary,
Index mutual funds offer several benefits such as eliminating fund manager bias, affordability, and low concentration risk. Do keep in mind that also pose certain challenges such as a cap on the maximum returns that one can earn and not giving the investor any control over their investments.
