While investing in the market you need to keep one thing in your mind. The thing is that allocating funds in the market comes with a lot of risks. While it might look sensible to invest when the market is performing well, when it is in turmoil, you may be tempted to withdraw from your mutual fund investment. However, instead of redeeming mutual funds, you should consider investing in this fund or its numerous variants like index funds. “What is an index fund?” you may ask. Continue to read below to know more:
What are index mutual funds?
This type of mutual fund is a passively managed investment tool that not only tracks market index benchmarks like the SENSEX, NIFTY Next 50, and NIFTY 50 but also tries to imitate their performance. For replicating the performance of an index that’s chosen, index mutual funds hold on to the shares which are a part of the chosen index. It is important to make note of the fact that the said shares are bought in the same proportion as the index fund is replicating. However, to understand how these funds work, you need to understand what active and passive management is when it comes to mutual funds.
Under actively managed mutual funds, you first opt for a scheme, and then a professional referred to as the fund manager uses their expertise inbuilding a portfolio consisting of securities. The fund manager with the help of their team takes tactical calls. They also decide which stocks to either buy or sell and even at what price. As this type of fund allocation regularly involves multiple buying and selling transactions, it is referred to as active investing. And schemes that make use of this strategy are called in the investment circles actively managed mutual funds.
Conversely, under passive investing, after building a portfolio of stocks, the fund manager preserves the allocation of individual stocks in the same proportion as the replicated index. Also, in contrast to active investing, the fund managers who are investing passively don’t have the freedom to select the stocks to invest in. Instead, they are responsible for making sure that the fund is replicating the portfolio of the chosen index. Index funds, which are known for replicating specific indices like the NIFTY Midcap 150 are known for following the passive strategy, and therefore, are examples of this type of investment.
How do they work?
Once an investor has opted for an index fund, their money is pooled with other investors. The fund manager later allocates the said money to bonds and stock. These are instruments that make up an index. While funds may or may not be allocated to every component of an index,a fund manager aims to get an appropriate sample of every piece. This is done to effectively track the index performance over time.
Are there any benefits to investing in index funds?
Known for offering numerous advantages over actively managed funds, index funds, in recent years have surged in popularity amongst many investors. Some of the reasons behind their popularity are:
- They are very affordable:
One of the best features of index funds is that managing them does not require a team of analysts.Therefore, managing index funds cost significantly lower than those that are actively managed (for example equity mutual funds). Furthermore, even the top-performing index funds do not engage in active trading. This reduces portfolio churn, which results in a lower expense ratio of these funds, which contrasts with an actively managed scheme.
- There is no risk of bias:
In these funds, a fund manager makes sure to only replicate the index which is being tracked. This ensures that there is no bias in the mind of the manager when it comes to stock selection. For instance, if your index fund is tracking the NIFTY Next 50 Index, the scheme will only invest in the 50 stocks that make the Next 50 Index. As fund managers don’t need to select the stocks by themselves, there is no risk of personal bias.
- These funds offer diversified investments:
Index funds typically are a basket of stocks that are already diversified across different sectors. Since the portfolio of a mutual fund is known for replicating the chosen index in every respect, these funds are known for offering investments that are spread across multiple sectors. This helps in reducing concentration risk. Actively managed funds, on the other hand, are known for not being able to provide a high degree of portfolio diversification at low costs.
What to do with index funds during a volatile phase?
As stated earlier, investing in the market comes with a high degree of risk. When there is a dip in the market it is understandable when someone is tempted to redeem their investments. However, instead of redeeming, you should do something which is referred to as “Buy the dips”. In simple words, buying dips refers to the act of purchasing an asset when its price has experienced a drop. The purchase is made with a belief that the drop is just a short-term glitch and with time, the asset’s value will rise again. The dip might be happening because of situations that are beyond the market’s control such as a pandemic or war. Therefore, sharp corrections, which are a response to short-term events, should instead be seen as an opportunity to invest more into the market as things will not be the same. Simply put, don’t redeem your investment. Continue investing in index funds through SIP. Things will turn around.