Investing via index funds is a popular strategy in developed markets such as US, UK and Canada. In India, this strategy has failed to deliver. This is indicated with the poor response that index funds in India have received.
Having said that, investing in index funds has some clear benefits.
Here are a few reasons you should consider an index fund in your portfolio.
#1 You do not believe in fund managers
Fund managers are humans, after all. They can pick bad stocks, they can mistime the market, they can ignore long term trends and they can be a victim to various biases. If you are not comfortable making your money subject to a fund manager’s whims then index funds is your answer.
#2 You want to play a low cost strategy
Several investors chase returns as if they can control it. Wrong. The only thing that you can truly control is your costs – be it in business or in investing. With index funds, you control your costs of investment by eliminating the research costs and lower turnover costs. This way you play an absolutely low cost investing strategy. All these costs saved add up to your returns.
#3 You want to be fully invested in equity, at all times
As a smart investor, you decide your own asset allocation, that is, how much money should be invested into equity, bonds, real estate, gold and cash. For your equity portion, you choose equity mutual funds. You expect your mutual funds to be 100% invested in stocks all the time – in alignment with your asset allocation.
Now, if the active fund manager decides to hold cash based on his analysis of the market, it distorts your asset allocation. You hold your cash PLUS your fund manager also holds cash = Lots of Cash in your portfolio. It could also mean missing out on investment opportunities.
The way out is passively managed index funds. Most index funds are, usually, fully invested in the stocks which comprise the index. It is their mandate is to mirror the returns of the underlying index. Yes, the returns may not be close to what actively managed funds have been able to get but then you are more concerned about your asset allocation.
Pro Tips for Buying Index Funds
So, now if the idea of index funds appeals to you, here are a few pro tips to consider when buying index funds.
Pro Tip 1: If you plan to have an index fund in your portfolio, it is best to have a broad based index fund. What I mean by that is an index that captures a large part of the market, such as a CNX Nifty 500. The Goldman Sachs CNX 500 is one such fund. Please note that this fund is not a recommendation but only an example.
Pro Tip 2: If you are a beginner in stock investing, an index fund is a good idea to start with. It gives you exposure to a diversified portfolio at a very low cost.
Pro Tip 3: You can buy index funds directly with a mutual fund. you can also use your Unovest Account to by an Index Fund. Some of these funds are also available as Exchange Traded Funds or ETFs like a regular stock. Use your demat + trading account to buy one.
So, as you can see Index Funds can find a place in a portfolio, of course, with certain considerations. In another post, we will make data comparison of index funds with actively managed funds. Stay tuned.