A low-cost index fund is an excellent approach for both novice and experienced investors to invest in the stock market. When compared to individual equities, index funds can lower your risks and are an excellent option if you want to invest with the least amount of time and money possible. Additionally, index funds can potentially provide competitive returns by lowering your fees.
Here’s more information on how index funds work on the market.
Understanding Index Fund
An Index Mutual Fund, as its name suggests, invests in stocks replicating stock market indices such as the NSE Nifty, BSE Sensex, etc. These funds follow a passive management approach, meaning the fund manager doesn’t change the portfolio’s composition. Instead, they invest in the same securities that mirror the underlying index in the same proportions. The primary goal of these funds is to deliver returns that closely match the performance of the index they track.
How Do Index Funds Work?
Consider an Index Fund that aims to replicate the NSE Nifty Index. In this case, the fund’s portfolio will consist of 50 stocks in proportions that mirror the index’s composition. An index can comprise both equities and equity-related assets in addition to bonds.
The role of an Index Fund is to invest in all the securities tracked by the associated index. Unlike an actively managed Edelweiss mutual fund that strives to exceed the performance of its benchmark, an Index Fund follows a passive management approach, aiming to replicate the returns generated by the underlying index.
What is a Low-Cost Index Fund?
Due to their passive investment approach to portfolio management, index funds offer investors lower fund management fees than active funds. Consequently, index funds represent a cost-effective investment choice for individuals seeking broader exposure to benchmark indices. These low-cost index funds are characterized by minimal expense ratios, sometimes as low as 0.06%, setting them apart from other funds.
What Makes Nifty Index Funds Special?
- Diversification
Index funds enhance portfolio diversification by allocating investors’ capital across shares of companies from various sectors. This diversification serves to reduce the overall risk in the portfolio. In simpler terms, even if a particular sector performs poorly, investors’ portfolio value will not experience a significant impact.
- Low-Cost Investment
Index funds operate as passively managed Edelweiss mutual fund schemes, where fund managers do not actively participate in investment decisions. Consequently, they impose reduced management fees, reducing the expense ratio. In line with the recent regulations from the Securities and Exchange Board of India, fund management companies can apply a maximum expense ratio of 1% to this fund category. Consequently, the investment cost remains economical, enabling individuals to enhance their returns.
- Flexibility
Investors have the flexibility to either make a lump sum investment in index funds or opt for a systematic investment plan (SIP). By choosing the SIP approach, they can regularly allocate a predetermined amount to an index fund scheme, typically monthly or quarterly. Notably, one can initiate their investment in Nifty index funds with as little as Rs. 500 through a SIP.
- No Bias in Investing
Index funds are managed using an automated investment strategy, where fund managers adhere to a predetermined mandate specifying which stocks to purchase or sell and in what proportions. This approach eliminates the influence of human biases in the investment decision-making process. Now that you have a grasp of what index funds entail let’s explore the process of purchasing them.
Investing in Low-Cost Index Funds
The procedure for investing in low-cost index funds closely resembles that of other mutual fund schemes. Investors can visit an Official Point of Acceptance (POA) to submit a completed application form and a crossed cheque payable to the mutual fund house and the specified scheme.
Additionally, individuals have the option to digitally initiate investment transactions in index funds using the mutual fund house’s website or mobile apps, as well as the services of the Registrar & Transfer Agent (R&TA). Online transactions are available once the investor’s KYC verification linked to their PAN has been completed.
Importantly, once the investment process is executed, there is no distinction between mutual funds based on the investment mode. The same Net Asset Value (NAV) is applied to mutual fund units, whether acquired digitally or physically.
Things to Consider When Buying an Index Fund
While the investment portfolio remains uniform across different index funds that track the same index, one might contemplate the following factors when selecting an index fund:
Total Expense Ratio (TER)
As the expense ratio is levied on the scheme, it directly affects the fund’s returns. When comparing two index funds that follow the same underlying index, the fund with a higher Total Expense Ratio (TER) may yield lower returns.
Tracking Error (TE)
Tracking Error pertains to the variance between the investment portfolio and the underlying index. This variance can occur due to delays in implementing changes in the investment portfolio after they have occurred in the underlying index. A higher tracking error in an index fund corresponds to a greater difference between the fund’s performance and the performance of the underlying index.
Conclusion
The primary distinction between index funds following the same index is the cost factor. This is why experts advise investors to prioritize the cost of funds when considering options based on renowned indexes like the S&P 500. A fee that doesn’t contribute to the fund manager’s earnings is a potential source of compounded growth for your investments over the years.
