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    What are index funds?

    Synopsis

    Index funds, as the name suggests, invest in an index. They invest in stocks that constitute the index in the same proportion. The whole idea is to mimic the index. Why?

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    Index funds, as the name suggests, invest in an index. They invest in stocks that constitute the index in the same proportion. The whole idea is to mimic the index. Why?

    Well, countless studies have proven that it is not easy to beat the market consistently over a long period. So, why waste a lot of time studying about stocks, economy, various other data and trade regularly to beat the market? Instead, just invest in the index and save money and time. After all, frequent trading also involves paying various charges.

    Most developed countries investing in an index, called passive investing, is a major draw. Most investors are happy investing In low cost index to take care of their long-term goals like retirement. It is a simple strategy. You invest in an index fund. That is all. You don’t worry about the performance of the fund manager. If the market goes up, your fund will also go up and you will benefit from it.

    Index funds are still not very popular in India. This is mainly because many fund managers are still able to generate extra returns than their benchmark regularly. However, proponents of index investing say such outperformance will become rare once the market is fully developed. In such a market, all stocks are well-researched, and everyone knows almost everything to know about the company and stock. There is no extra advantage to anyone. So, the chances of making extra returns are remote.

    In a small way the trend is already visible in the large cap segment. Most passively-managed large cap index funds managed to beat actively-managed large cap funds in the last two calendar years. If they continue their performance for a few more years, it would strengthen the case of investing in large cap index funds.

    Active fund managers say limited rally in the large cap space has resulted in the poor show by most large cap funds, and they will stage a comeback once the broad market starts rallying.

    You have the option of investing in various indices like small cap, mid cap, large cap, etc. It is always better to invest in a popular index like Sensex, Nifty, Nifty 100, Nifty Next 50, and so on, than obscure indices.

    Also, you should be sure that the scheme has been able to match the index consistently over a long period. Index funds can lag their index funds for various reasons – this is known as tracking error. Do not look for zero tracking error, as it is almost impossible. Look for consistency.

    Apart from tracking error, you should also pay attention to the expense ratio of the fund. Index funds have a very low expense ratio, compared to their actively-managed counterparts. You need not go the scheme with the lowest ratio, but you must ensure that expense is within the average range.
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