Index funds: Pros and cons of investing in them

Index investing is a form of passive investing that involves buying and holding a portfolio of stocks that mirrors the constituents of a specific index with the aim to try and match the returns of that index, subject to tracking error. The fund manager of an index mutual fund creates a portfolio that has a proportionate representation of each security of the relevant index. Exchange Traded Funds or ETF investment also follow a similar passive approach and replicate the benchmark index.

This is unlike active mutual funds, where fund managers handpick stocks and try to potentially outperform the market.

In this article, we will provide an overview of index investing and its benefits and disadvantages for an investor.

Table of contents

Key features of index investing
Importance of tracking error
Overview of major Indian stock market indices
Pros and cons of investing in index funds
How to start index investing

Key features of index investing

Passive investment strategy: IIndex investing is a passive investment strategy that involves a “buy and hold” approach. The portfolio tracks the performance of a specific index.
Diversification: Index investing can provide exposure to different sectors and industries. This can potentially help to mitigate the risk associated with investing in a single stock or sector.
Relatively low cost: Passive index funds have relatively lower expense ratios compared to actively managed mutual funds. This is because index funds don’t require active management, as the portfolio is designed to track the index performance.
Tax-efficient: Capital gains from equity-oriented index funds may receive favourable taxation depending on the holding period. Investments held for more than a year are subject to long-term capital gains tax of 10% (as opposed to 15% short-term capital gains tax for a holding period of less than a year).

Importance of tracking error

Tracking error is a key metric in index investing. Tracking error is a measure of how much an index fund deviates from the performance of the underlying index. A higher tracking error implies a greater deviation from the benchmark returns. Tracking error thus helps gauge the performance of an index fund.

From an investor’s point of view, a lower tracking error is desirable as it indicates the ability of the fund to closely match the performance of the underlying benchmark.

Overview of major Indian stock market indices

Nifty 50: The Nifty 50 is a benchmark index that represents the performance of 50 of the largest and most liquid companies listed on the National Stock Exchange. It covers a wide range of sectors and is widely used as a benchmark for investment performance.
S&P BSE Sensex: The Sensex is a benchmark index that represents the performance of 30 of the largest and most liquid companies listed on the Bombay Stock Exchange. It is widely followed by investors and financial media as a gauge of the Indian stock market's performance.
Nifty Next 50: The Nifty Next 50 is an index that represents the performance of the next 50 largest and most liquid companies listed on NSE, after the Nifty 50. It provides a broader representation of the Indian stock market and can be a useful tool for investors looking to diversify their portfolio beyond the large-cap space.
Nifty Bank: The Nifty Bank index tracks the performance of the banking sector in India. It includes the largest and most liquid banking stocks listed on the NSE.
BSE Midcap: This represents the performance of the mid-sized companies listed on the BSE.
Nifty Smallcap: The NSE Smallcap indices represent the performance of the small companies (by market capitalisation) listed on the NSE.

Pros and cons of investing in index funds

Like any investment option, index funds come with their own set of advantages and drawbacks. Understanding the pros and cons can help investors decide whether index funds align with their financial goals and risk tolerance.

Pros

Enables easy diversification through one investment.
Has a lower expense ratio than actively managed funds.
Can be appealing to new investors who would rather diversify through one investment than through a basket of mutual funds.
Investing in index funds is straightforward, making them ideal for beginners and those seeking a hands-off approach.
Being passively managed, index funds mitigate the risk of decisions by fund managers affecting scheme performance.

Cons

The fund does not aim to outperform the benchmark index, which may, in some market conditions, reduce return potential.
Fewer choices for investors as compared to active mutual funds.
Index funds are subject to tracking error, which is the deviation between a scheme’s performance and that of the benchmark index.

Getting Started with Investing in Index Funds

Here are the steps to get started with investing in index funds:

Understand index funds: Learn about different indices and the funds that track them to choose one that aligns with your investment goals.
Set investment goals: Determine your financial objectives, risk tolerance, and investment horizon. Equity-oriented index funds can be suitable for long-term goals as they have the potential to build wealth over time but are vulnerable to volatilities, especially in the short term. To estimate the potential returns on your investment, you can use an SIP mutual fund calculator.
Choose the right fund: Compare various index funds based on their expense ratio, tracking error, and the underlying index they follow. Lower expense ratios and minimal tracking errors are desirable.
Start investing: Start with a lumpsum or set up a Systematic Investment Plan (SIP) for disciplined investing. You can invest directly through the asset management company, or through a distributor or aggregator platform.
Monitor: Periodically review your investments to ensure they align with your goals.

FAQs

What are index funds?

Index funds are pooled investment vehicles that aim to replicate the performance of a specific market index. They offer investors exposure to a diversified portfolio of stocks or other assets.

What is an investment index?

An investment index, also known as a market index, tracks the performance of specific assets like stocks or bonds, serving as a benchmark for market performance.

What is index investing?

Index investing is a passive strategy where investors aim to replicate the performance of market indices, such as the S&P BSE 500 or the Nifty 50, rather than selecting individual stocks to beat the broader market.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.