Index funds are “passive investments”, meaning they do not aim to outperform the market. Instead, they faithfully track the performance of the underlying index without active stock picking. Due to this passive approach, index funds generally have lower costs than actively managed funds, as they do not require a team of investment professionals.
Long-term investors often favour index funds because they provide the potential for market-like returns with reduced risk. The passive strategy and cost-effectiveness make them a popular choice among those seeking stable growth over time.
How to choose your index fund?
The index fund you choose depends on your choice of asset allocation. Asset allocation is a strategic approach to diversifying investments across various asset classes, such as equity, debt, and international equity, each with its own risk and return characteristics. By spreading investments across different asset classes, investors can strike a balance between risk and return, reducing overall portfolio risk and maintaining investment discipline. Utilizing index funds facilitates low-cost diversification across these asset classes.
Here are some key benefits of asset allocation:
- Risk reduction: Allocating investments across different asset classes lowers the overall risk of a portfolio. As different asset classes tend to move in different directions, poor performance in one class may be offset by better performance in others.
- Return enhancement: By investing in diverse asset classes, the potential return of the portfolio can be increased. Each asset class carries its own risk and return profile, so having a mix of assets can enhance the chances of achieving investment objectives.
- Discipline in investments: Asset allocation fosters disciplined investing by encouraging investors to focus on their long-term goals and how to achieve them. It helps avoid making impulsive decisions, such as selling investments during market downturns, by aligning investment choices with overall objectives.
Asset allocation is a valuable strategy to reduce portfolio risk and maintain investment discipline. By diversifying investments across different asset classes, the impact of any single asset class on the overall portfolio is mitigated. This approach provides peace of mind, knowing that the portfolio is not overly exposed to any specific risk factor.
Index funds offer an excellent and cost-effective means of diversification. These funds are passively managed and designed to replicate the performance of a specific market index, like the S&P 500 or the Dow Jones Industrial Average. Rather than attempting to outperform the market, index funds aim to closely mirror its performance. This approach provides investors with a straightforward and effective way to achieve broad market exposure without the need for active management.
Index funds offer a cost-effective avenue to achieve diversification across various asset classes.
- Equity Index Funds track equity market indices (e.g., Sensex, Nifty, Bank Nifty, etc.)
- Debt Index Funds track debt market indices (e.g., G-Sec and/or SDL indices with target maturity dates)
- International Index Funds track international indices (e.g., NASDAQ, S&P 500, etc.)
Investing in index funds to induce portfolio diversification
Index funds excel in providing true diversification by tracking a wide array of securities, thereby, reducing overall risk. Investing in a midcap index fund, for instance, grants exposure to all midcap stocks in the index, not just a select few. As a result, the portfolio becomes less susceptible to the performance of any individual stock or sector.
In contrast, actively managed funds typically hold a limited number of stocks, making them more vulnerable to unsystematic risk specific to certain stocks or sectors. Index funds, however, avoid this risk by encompassing a diverse range of securities.
In essence, index funds facilitate risk reduction through genuine diversification. Their broad-based tracking of multiple securities means that the portfolio is less sensitive to the ups and downs of any single stock or sector.
To illustrate, consider investing ₹10,000 in a midcap index fund tracking 150 midcap stocks. In the event of one stock going bankrupt, it would only affect a small portion of the portfolio. On the contrary, investing the same amount in a single midcap stock would expose the entire investment to the bankruptcy risk of that single stock, with potentially significant consequences.
In summary, index funds offer a valuable advantage of risk reduction through true diversification, making them particularly beneficial for long-term investors.
A look at the following table highlights how investing in a particular index over 10 years can help earn you decent returns in the long run.
Name of the index fund
10-year returns (in %)
UTI Nifty 50 Index Fund
ICICI Prudential Nifty 50 Index Fund
HDFC Index Fund
Nippon India Index Fund
ICICI Prudential Nifty Next 50 Index Fund
LIC MF Nifty Next 50 Index Fund
|Source: MoneyControl (As on August 01, 2023)|
Both active and index funds serve vital roles in your investment portfolio. Active funds carry the potential for higher returns but also come with increased risk. On the other hand, index funds are less risky but tend to yield lower returns.
Your core portfolio, acting as the foundation of your investments, should consist of holdings you are comfortable with and plan to hold for the long term. A blend of both active and index funds can be included in your core portfolio.
Index funds offer a cost-effective method to invest in the stock market, featuring lower fees compared to active funds, leading to potential cost savings over time. Additionally, index funds provide the convenience of not requiring you to select individual stocks, making them a straightforward and hassle-free investment option.