When stock market growth seems to play a hide and seek with investors, one can play safe and invest in index funds to minimise the losses and to keep volatility low. There are several ways to map your earnings to the key indices such as Nifty 50 or S&P BSE Sensex.
Ace investor Warren Buffett in February 2019 told CNN that he finds it hard to beat the benchmark index S&P 500, and asserted that index is still the best way to invest for most people.
READ MORE: How to select the right ETF? A key guide
Why should you invest in index funds?
Investors can either select a mutual fund that invests in index funds, or the index-tracking exchange traded funds (ETFs) which are tradeable on stock markets.
One can build a diversified portfolio with just ETFs. When you invest in index funds, you don't need to keep a track of the funds to remove the poorly performing funds and replace them with good funds.
ETFs are introduced by asset management companies (AMCs). They choose an index and invest in stocks in the right proportions to match the index.
Some of the commonly traded Nifty50 ETFs include Mirae Asset Nifty50 ETF, HDFC Nifty 50 ETF and DSP Nifty50 Equal Weight ETF. The first two invest in 50 stocks in the same proportion as Nifty index does, while the third one invests in equal proportion which means 2 percent in each of the 50 constituent stocks of Nifty.
NAVs of ETFs
One thing that needs to be understood about ETFs is that the net asset value (NAV) of a fund is what you will pay to buy the units because the fund units are being sold on the stock market after they are listed.
Ideally speaking, NAVs should reflect the market index (minus expenses). But it doesn’t actually happen. The market price is also determined by the demand for the fund.
For instance, when there is a higher demand for the ETF, its net asset value will increase, and when the demand falls, its asset value will decrease.
In other words, the ETF with more demand would rise higher than the increase in underlying index. The ETF with poor demand would fall steeper than the fall in its underlying index. This means the net asset value will stay out of sync with the index which the fund is linked to.
The AMCs that run their funds efficiently are supposed to curb these out of sync movements by drawing more buyers when demand falls short, or by selling extra units when demand surges disproportionately.
So, it is vital to check how far the return of ETF deviates from the index movement. This difference is known as tracking error. And wider the tracking error, the more badly managed is the fund, and smaller the tracking error, the more efficiently managed is the fund.
We can summarise by highlighting that investing in index tracking funds may be the safest, if not the best, way to keep the losses to the minimum and extreme volatility at bay.