5 things to know about index investing

Investment practices in India have been primarily characterized by a penchant for investment avenues that carry little to no risks with a parallel aversion for riskier asset classes. However, the younger coterie of investors is slowly breaking away from those established norms and is deftly venturing into riskier pastures. More and more investors are acknowledging the importance of portfolio diversification and have started looking at all asset classes with fresh eyes.

Diversification is crucial for maintaining financial health in the long run. With diversification, your investments are spread across multiple asset classes. This ensures that when one asset class underperforms, the effects do not get concentrated in your portfolio, and the other asset classes absorb the shock waves. The underlying idea is that different asset classes seldom exhibit the same trends and have little correlation at any given point in time.

Thanks to the ease and flexibility mutual funds offer, they are steadily becoming the preferred investment vehicle for many investors. However, those new to the investment landscape can find the narratives around mutual fund investments and fund management a tad tricky. This is where index investing emerges in the picture. Here are a few things you need to know about index investing:

What is an index fund?

An index fund is a mutual fund scheme wherein the portfolio is made to mimic the components of a financial market index. When you invest in an index fund, your money will be invested in all the companies that make up the index the fund replicates.

For example, if a mutual fund scheme mirrors the Nifty 50, it would have investments in the same 50 stocks in its portfolio that make up the Nifty 50 Index. The weights of these stocks in the fund would also be the same as those of the index against which the scheme or the fund is benchmarked.

How did index funds come into existence?

The first index fund was launched in 1976 by John C. Bogle, also known as Jack Bogle, the founder of Vanguard, an American asset management company. The fund was initially called the First Index Investment. It tracked the S&P 500 index and was later renamed Vanguard 500 Index Fund. The fund's launch was an abject failure – so much so that it earned the label 'Bogle's Folly .' However, the fund crossed the $1 billion mark in 1990 and happens to be one of the largest mutual fund schemes in the world today.

How do index funds work?

The fund manager selects an index to track. Usually, it represents a broad market segment, such as large-cap stocks, small-cap stocks, or international stocks. They then create a portfolio of stocks or other securities that matches the composition of the selected index. As opposed to actively managed funds, index funds are passively managed, meaning fund managers do not try to outperform the market. Rather, they aim to replicate the index's performance by holding the same stocks in the same proportion. In addition, they do not try to select stocks or time the market by strategizing when to buy and sell them, as is the case with actively managed funds.

How can index funds help achieve diversification?

Companies in India fall under different indices on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) based on the industry they belong to and their market capitalizations. Thus when you invest in index funds, your money will be invested in not just one company or industry but across companies, sectors, and market capitalizations, thus helping you build a diverse portfolio. This holds in the case of funds that are benchmarked against fixed-income indices, too, wherein assets such as government securities, T-bills, corporate bonds, and commercial papers are included. Index funds are suitable for long-term goals. In the short term, index funds can experience fluctuations, but in the long run, volatility risks are ironed out , and they generate better attractive returns.

Why do index funds have a lower expense ratio than active funds?

Index fund managers build and maintain portfolios by imitating the holdings of the securities of a particular index. On the other hand, fund managers of actively managed funds have to spend considerable time and effort researching and crafting strategies for selling and buying securities to generate alpha. Since fund managers are not actively buying/selling securities, index funds have lower expense ratios than their actively managed counterparts .

An Investor education and Awareness initiative of Aditya Birla Sun Life Mutual Fund

All investors have to go through a one-time KYC (Know Your Customer) process. Investors to invest only with SEBI registered Mutual Funds. For further information on KYC, list of SEBI registered Mutual Funds and redressal of complaints including details about SEBI SCORES portal, visit link : https://mutualfund.adityabirlacapital.com/Investor-Education/education/kyc-and-redressal for further details.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully

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