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investment strategy: Planning to invest in Index Funds? Check the pros and cons

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In recent times, investor interest has been rapidly increasing in passive index strategies. 2021 has already seen the launch of over 15 index funds and ETFs (exchange-traded funds). The figure for entire 2020 was just 17.

What are index funds?

Index funds replicate the weightages of companies that form part of the benchmark index under consideration. The weightage of the stocks in the fund will closely match the weightage of each stock in the index. In case od a change in the weight of stock within the index, the fund manager too will make changes to have its weight in the portfolio aligned to that of the index. For example, a Nifty index fund will invest in the 50 companies forming the Nifty50 index.

Benefits of Index Funds

Diversification: Index funds, in a simple and easy manner, provide diversification by investing across many stocks. Take Nifty 50 index. Through this index, an investor gets access to 50 different companies. As a result, the value of one’s portfolio will not be adversely impacted in the event of any negative development in any one of the companies which is a part of the index. Furthermore, this diversification comes with a ticket size as low as Rs 100.

Lower Costs: Costs associated with an index fund are generally very low. The total expense ratio (TER) for an index fund, as per market regulator SEBI, is capped at 1 percent. When compared to actively managed counterparts, this turns out to be a cheaper option for an investor who is comfortable with index fund investing.

Return Potential: The aim of an index fund is to generate returns as close to that of its underlying index. Over the long term, if an investor is ready to stay invested, the return profile is likely to reflect the growth of the economy. For example, the 5-year CAGR of an index like Nifty 50 TRI is about 15%.

SIP Facility: Just like any actively managed fund, investors can opt for daily, weekly, fortnightly, monthly, or quarterly SIP options.

Limitations of Index Funds
Lack of Flexibility: Unlike an actively managed fund, if there is any material development in the economy or markets, the fund manager here cannot make any changes to the portfolio. As a result, there is no scope for the fund manager in managing market downsides.

No room for Alpha: By investing in an index fund, the investor is signing up for returns that will be in line with that of the index which the fund is tracking.

Tracking Error: Tracking error is the difference between the scheme’s return and the benchmark index’s return. While index funds try and replicate an underlying as close as possible, there is likely to be a gap due on account of factors such as expenditure incurred by the fund, cash balance, or portfolio deviation.

Who can consider investing in Index Funds?
Every Investor should have index funds as part of their asset allocation. First-time investors may also consider index funds as a stepping stone into the world of equities. In the short term, returns could be volatile but over the long term the fluctuations average out. To conclude, an index fund offers one of the cheapest ways to take exposure to equity markets but before investing do check if the fund matches your risk appetite, investment horizon, and financial goal.

The author, Chintan Haria, is Head- Product Development & Strategy, ICICI Prudential AMC. The views are his own.

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