Index funds are designed to replicate the performance of their underlying portfolio. These funds give investors an opportunity to spread their portfolio across securities of a specific index without changing portfolio composition. Index funds that invest in NIFTY have a portfolio comprising of the top 50 company stocks. Similarly, an index fund that invests in SENSEX will comprise of top 30 underlying stocks that form the index.
Because the fund manager of an index fund does not actively buy or sell securities from its underlying portfolio to generate capital appreciation, it is called a passive fund. The fund manager does not have to do intrinsic research to pick stocks for the index fund portfolio, neither do they have to manage the fund actively or decide which stocks to hold or which stocks to sell. This type of investment style is considered passive where the index fund aims to replicate the performance of its underlying securities rather than trying to outperform the benchmark like most other schemes.
Since these funds mostly invest in indexes that comprise of top 50 or top 30 company stocks, they give investors exposure to bluechip stocks. Blue-chip stocks consist of stocks belonging to large cap companies that are financially stable and have a solid reputation in the industry. Hence, investors who want exposure to a portfolio of securities that are less volatile than other equity oriented mutual fund schemes can consider investing in index funds.
Are index funds a low cost investment?
As mentioned earlier, index funds are passively managed. Although they have a fund manager overlooking the overall performance of the portfolio, there is very little participation involved. This makes index funds a cost effective investment option as opposed to other actively managed mutual funds that have a relatively high expense ratio.
The expense ratio of an index fund is usually below 1%, sometimes even less than .50%. For those who do not know, the expense ratio is the total recurring costs like management fees, operational costs, etc. which the Asset Management Company must take care for ensuring the smooth operation of the index fund. These expenses are recovered by the AMC by levying an expense ratio on the mutual fund. The expense ratio isn’t an additional charge but is a sum that is deducted from the investor’s total capital gains. In the long run, those who invest in mutual fund schemes with a high expense ratio might end up giving away a large portion of their capital gains.
Can you create wealth with index funds?
To create wealth with market linked schemes like index funds, investors need a long investment time horizon spanning over 5 to 7 years or more. That’s because even if you look at the stock market, you need to have patience to create wealth. Equity markets are volatile in nature and investments made in equity can generate negative returns in the short run.
Also, if you are planning on building a wealth corpus that can be Rs 1 crore or more, you need to start a monthly SIP in index funds. Systematic Investment Plan allows retail investors to save and invest a fixed sum regularly in index funds. Investors can decide an amount that they are comfortable investing and invest that sum regularly till their investment objective is accomplished. Investors who don’t know exactly how much to invest regularly to get closer to their ultimate financial goal can take the help of the online SIP calculator.
However, the key to long term wealth creation is systematic and disciplined investing and investors must ensure that they do not stop their investment journey midway.