As an investor, choosing an index fund that aligns with your financial goals is an important decision. According to a survey conducted by an asset management company, 87 percent of respondents in India opt for index funds, while only 42 percent choose ETFs.
The survey shows that retail investors’ preference for index funds is attributed to low cost, simplicity, and market returns.
Let’s understand the key factors to consider when evaluating index funds to find the one that is best for your investment portfolio.
What are index funds?
As an investor, if you are new to the stock market, index funds in India can be an excellent way to get started. Index funds are passively managed mutual funds that track the stock market index’s performance like the NIFTY or SENSEX. They provide broad market exposure and better returns than fixed deposits.
- These funds have lower fees since they are not actively managed. The expense ratios are typically less than 1% per annum versus 2-3% for actively managed funds. The lower costs translate into better returns for you over the long run.
- Index funds offer instant diversification. By owning all the stocks in an index, you mitigate the risks of individual companies. This makes them ideal for first-time investors, like you who are looking for a hassle-free way to invest in equities.
- The performance of index funds closely mirrors the underlying index. While active funds aim to outperform the market return, it is a worthwhile strategy.
Factors to consider when choosing an index fund
When choosing an index fund, there are several factors to consider:
Fees and expenses
Index funds typically have lower fees than actively managed funds since they are passively managed. Look for a low expense ratio, ideally below 1%. The lower the fees, the less they will eat into your returns over time.
Investment objective
Determine if you want an index fund that tracks the overall stock market or a specific sector, market cap or style like large cap, mid cap, small cap, growth or value. Choose an objective that matches your financial goals and risk tolerance.
Tracking error
This measures how closely the fund replicates the performance of its benchmark index. A lower tracking error means the fund closely matches the index. Look for a fund with a tracking error of less than 0.5% to minimise the deviation from the benchmark.
Assets under management
Larger funds may have lower fees and trading costs. However, very large funds can sometimes have a higher tracking error. Look for a fund size that balances lower fees with the ability to efficiently track its index.
Liquidity
For easy buying and selling, choose an index fund with high daily trading volumes. Liquid funds allow you to get in and out of positions quickly without substantially impacting the share price.
Holdings and allocation
Compare the fund’s holdings and sector allocations to its benchmark index to ensure they are closely aligned. The closer the fund mimics the index, the more accurately it will track performance.
Bottom line
Choosing the right index fund for your portfolio is crucial to achieve your long term financial goals. So start early, invest regularly, keep costs low, diversify and stay invested for the long run.
