Welcome to the world of passive investing, where accumulating wealth is possible even without spending hours browsing the right stock and worrying about how to build your portfolio. In this blog, we’ll dive into the basics of passive investing, exploring the concept of index funds. For those new to the investing game or just seeking a better understanding, we’ll break down the concept of index funds, how they work, and why they might be considered a wise investment option for building a solid financial foundation. But first, let’s get a picture of what passive investing is.
What is Passive Investing?
If you are new to investing and looking to achieve long-term returns, passive investing might be the way to start. Why? Passive investing allows you to invest hassle-free and gives potential to earn returns in the long run without worrying much about market conditions.
Passive investing instruments track the performance of market indices rather than actively trying to beat them through individual active stock selection. This approach involves low-cost index funds, exchange-traded funds (ETFs), or similar investment vehicles holding a portfolio of stocks or other assets that closely mirror the index.
The focus of passive investing is to achieve broad market exposure and to minimise investment costs and management fees. Let’s understand one such element of passive investing — Index Funds.
What is an Index Fund?
An index fund is a mutual fund that imitates stock market indices such as Sensex and Nifty. Sensex carries a list of 30 top-performing companies, while Nifty 50 holds the top 50 companies with the largest market capitalisations. The index funds that mirror these indices also invest in the same companies that are a part of these indices. Hence, when Sensex or Nifty performs well, the index fund simultaneously provides similar returns. The objective of investing in an index fund is to provide investors with exposure to the broader market rather than trying to beat it through active stock picking. Hence, Index funds can be a goldmine of stock picking since they invest in financially sound companies of the index.
How does an Index fund work?
In India, index funds are usually offered as mutual funds, where a fund manager invests in the stocks included in the target index in the same proportion as the index. By investing in an index fund, investors can benefit from the market’s long-term performance while avoiding the risks and costs associated with active fund management. Additionally, index funds are typically low-cost and offer the advantage of automatic diversification, which helps to reduce the overall risk in an investment portfolio.
Pros and Cons of Index Funds
- Low Costs:
Index funds typically have low management fees and expenses compared to actively managed funds, which can result in higher returns over the long run.
Index funds provide automatic diversification, as they hold many stocks, which helps reduce the portfolio’s overall risk.
- Ease of Investment:
Investing in index funds is simple, as they follow a set benchmark and do not require extensive research or analysis.
- Market Exposure:
Index funds provide investors with exposure to a broad market rather than just a few individual stocks, which can result in less volatility and better long-term performance.
- Limited Potential for Outperformance:
Since index funds simply track the market, they may not provide the potential for outperformance compared to actively managed funds.
- Lack of Active Management:
Index funds do not have a fund manager who makes investment decisions based on market conditions or individual security analysis, which can result in missed opportunities.
- Market Risk:
Index funds are subject to market risk like any other investment and can experience losses if the market declines.
Once invested, index funds may not allow for changes in the portfolio mix or changes in investment strategy, which can limit the ability to take advantage of market opportunities.
- Index Dependence:
Index funds depend on the benchmark index’s performance, and changes in the index composition or methodology can affect the fund’s performance.
Who should invest in Index Funds?
- Index funds can be a good investment option for beginner investors looking for a simple and straightforward way to invest in the markets. Since index funds require minimal research and analysis, one only needs to investigate a little before investing.
- It is also an ideal choice for people looking to invest for the long term to save up for retirement or other major financial goals.
- Moreover, index funds have low management fees and are economical when it comes to other expense ratios. Hence, if you are a cost-conscious investor, index funds might be the right pick.
- Also, if you are a diversification-focused investor, index funds will provide you with automatic diversification, which helps reduce the overall risk of your portfolio.
- Index funds focus on the long term without worrying about outperforming the benchmark, making it the ideal investment choice for investors with long-term financial goals.
- Index funds provide exposure to a broad market. They can provide decent returns with less volatility compared to actively managed funds, making them a good choice for investors with a moderate risk tolerance.
Remember that while index funds can be a good investment option for many individuals, they still carry market risk, and it is important to consider your overall financial goals and risk tolerance before making any investment decisions.
Who should not invest in Index Funds?
Index funds may not be the best investment option for everyone, and some individuals who may want to consider alternative options include
- Short-term Investors: Index funds are designed for long-term investments and may not be suitable for individuals seeking short-term gains.
- Active Traders: Index funds do not provide the potential for outperformance compared to actively managed funds and may not be suitable for individuals who enjoy actively managing their investments.
- Investors Seeking High-risk/reward Opportunities: Index funds provide exposure to a broad market but do not provide the potential for high returns compared to more high-risk investments.
- Investors with a Low-Risk Tolerance: While index funds provide a more diversified investment option compared to individual stocks, they still carry market risk and may not be suitable for individuals with a low-risk tolerance.
- Investors with Specific Investment Goals: Index funds provide exposure to a broad market but do not allow for changes in the portfolio mix or investment strategy, which may not be suitable for individuals with specific investment goals.
Frequently Asked Questions
- What is the difference between index funds and actively managed funds?
Let’s start with understanding active funds first. Actively managed funds are managed by a professional fund manager who actively buys and sells securities to provide competitive returns. These funds are usually intended to outperform the market indices. Whereas, index funds are passively managed, meaning they follow a set market index like Sensex or Nifty 50. They do not require active management. For instance, Motilal Oswal Nifty 50 index fund invests in all 50 companies listed in the index in the proportion of their respective market size.
- What are the different types of Index Funds?
There are 8 types of Index Funds:
- Broad Market Index Funds: It tracks the major segment of the entire stock market, giving you exposure to a variety of stocks and market caps. Eg: Motilal Oswal Nifty 500 Fund, Russell 3000 ETF, etc.
- Market Capitalization Index Fund: These index funds track the indices based on market capitalization of underlying stocks. Meaning, large companies take up a larger portion of the funds assets and small companies take up a smaller portion of the funds assets. Eg: Sensex, Nifty 50, Nifty Next 50, etc.
- Equal Weight Index Fund: Unlike market capitalization index funds, these funds give equal weightage to all stocks of the index regardless of their market cap.
- Smart Beta Index Funds: These index funds use factors like size, value, and quality of stocks in the index to create an index mutual fund.
- Sector-Based Index Funds: These funds or ETFs are sector specific and only invest in a targeted sector like Finance, IT, Healthcare, Infrastructure, etc.
- International Index Funds: International index funds track funds of indices of foreign stock exchanges, like NASDAQ and S&P 500.
- Debt Index Funds: Debt-based index funds invest in fixed income instruments like bonds, corporate debt securities, etc.
- Custom Index Funds: Custom index funds allow advisories to formulate their own personalized fund, but under passive investing frameworks.
- How many index funds should I invest in?
The number of index funds you should invest in totally depends on your investment goals, risk tolerance, and overall financial situation. Generally, a diversified portfolio of 2 to 4 index funds is a good starting point, with the specific number ultimately depending on your unique financial situation.
- Are index funds only for long-term investors?
Index funds can be suitable for both short and long-term investors. However, these funds are recommended more for long-term investors. This is because index funds tend to mirror the stock market indices, often known to provide steady returns over the long term.
- What is the minimum amount needed to invest in index funds?
You can start investing in index funds for as low as ₹500.
- Can I build a diversified portfolio using only index funds?
As a beginner, it is okay to start by investing in index funds alone. However, since index funds invest in a single market index, they might not provide you with asset diversification. In order to add healthy diversification to your portfolio, one can add other low-correlation assets like bonds and gold to their portfolio.
Disclaimer: This blog has been issued on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this document is for general purposes only and not a complete disclosure of every material fact. The information/data herein alone is not sufficient and shouldn’t be used for the development or implementation of an investment strategy. It should not be construed as investment advice to any party. All opinions, figures, estimates and data included in this blog are as on date. The blog does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Readers shall be fully responsible/liable for any decision taken on the basis of this article.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.