Index Mutual Funds – Concept, Workings, Benefits, Features, Drawbacks & moreLast Updated Date: Nov 17, 2022
Perhaps you might have never heard about Index Mutual Funds before.
It is the safest yet highly profitable investment option. If you are planning to park money at a reliable and secure port, of course, it is the index mutual fund that will live up to your expectations.
What is Index Mutual Fund? Why should you invest in it? What are its advantages and side effects? And which things you’ll consider before investing in it?
In this article, we’ve shared a detailed overview of this amazing investment plan. So let’s begin the discussion.
What is an Index Mutual Fund?
Index Fund is one of the best Mutual Fund plans. However, not so many people are aware of this mutual fund category.
In simple words, these funds invest in an ambient market index like the NSE, Nifty, and Sensex.
Like a diversified portfolio holds multiple asset classes and diversify them further, Index Mutual Funds work upon the same principle with a notable difference.
All the funds in this mutual fund scheme are passively managed. The indices of a group of shares in the Index Mutual Fund represent a similar performance within its portfolio.
It eliminates the need for actively managed portfolio as it tracks the benchmark index which provides a quick overview of the portfolio performance.
Such as, the returns from investment become easy to predict. However, the passively managed portfolio also reduces the expense ratio.
In a nutshell, these mutual funds focus more on maintaining the portfolio’s uniformity instead of growth. It ensures a safe portfolio for investors.
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How does Index Mutual Funds Work?
The overall behavior of an Index Mutual Fund is quite interesting to know.
For instance, instead of actively managing funds, the manager of these funds builds a portfolio whose entire holdings can be viewed through one eye.
The securities of a specific index mirror the profile of another index. Thereby a manager can get a thorough insight into the performance of holdings through a single segment.
Let us understand it better through an example. A portfolio comprises of 100 Nifty stocks or instruments in an identical proportion.
Index refers to a group of instruments from a specific market segment. Hence, the 100 nifty stocks can be categorized as one index of a portfolio.
Since one index tracks a benchmark index to derive the insights, it eliminates the need for repetitive efforts for a portfolio’s ‘active management’.
If one or two index is tracking the similar index, it’s likely to offer the same returns. That’s why these funds fall under the passively managed fund category.
The fund house manager of these funds purchases and sells out the stocks as per the benchmark performance.
However, it isn’t that easy as it sounds, because a team for research analysis is specially appointed to detect the ‘mushrooming opportunities’ in the market.
Also, it doesn’t matter at all whether the index contains equity-oriented instruments or bond market instruments as it can be any type of ‘instrument.’
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Who should Invest in Index Funds?
Here comes another most critical question. People often ask whether they should invest in the Index Funds or not.
If you’re an experienced investor, you also know that every investment plan comes with its own risk and returns profile.
That’s why before you step in the Index Mutual Funds, get an idea of your investment goals and risk appetite.
However, for the risk-averse investors, index mutual fund can prove to be an ideal option.
It follows the diversification pattern, which ensures the safekeeping of a portfolio from the market fluctuations.
One can earn the predictable returns that make it a unique investment plan that doesn’t ask you for extensive analysis.
For example – you can invest in Sensex and Nifty index funds if you don’t want to invest in equity funds that contain higher risk and seek an actively-managed portfolio.
However, you can also earn higher returns through an actively managed portfolio. But it’s only possible in long-run.
Actively managed portfolio for a short-term goal will provide you similar returns from index funds with no difference.
Benefits of Investing in the Index Mutual Funds
Index mutual fund is an advantageous investment plan in multiple ways. If we talk about the primary advantages, so these are as follows –
Typically, mutual funds schemes are either actively managed or passively managed.
Though, both options have their own underlying benefits, such as, the fund manager who actively monitors the performance of stocks works intending to beat the market returns.
He can actively buy and sell the stocks to capture a higher return out of it.
However, it’s the best way of earning huge from the financial market. Still, a little wrong-decision can put you into a big loss.
On the flip side, the passively-managed portfolio comprises buying and holding of assets for a given point of time to match the index performance.
Though the primary focus of such types of funds is to assure a portfolio’s uniformity and keep providing better returns to the trader without any risk.
It makes the Index Mutual Funds a way better option for investors.
Index Mutual Funds don’t invite higher expenses.
The primary reason behind it is that these funds are actively managed, which invites higher cost as more market analysis experts will be required.
On the other hand, if a portfolio is passively managed, the assets will be purchased and held for a given time only.
It makes such investment less expensive option as there’s no need for a team of experts for analysis.
That’s why the big reason why index mutual fund proves to be less expensive is its portfolio is passively managed.
Still, you will have to keep your eyes on the expense ratio as mentioned by a fund house. It will provide you with an insight into how much money is working for the operation.
If the expense ratio is low, it will secure an attractive margin for you.
If you’re willing to invest in Index Mutual Funds, you will get an added advantage of tax alongside. It’s because of the passively-managed profile of the portfolio, which ensures lower turnover.
It reduces the implications of the risk. Thereby investors can confidently park their money in this investment plan.
The broad diversification in the index funds ensures a higher return to the traders from the multiple segments.
For instance, index funds can invest in more than hundreds or thousands of instruments; it implies that an investor can generate a ‘good amount of return.’
However, if an investment comprises of 50 holdings, it can be actively managed. Such investment if held for a longer period, one can easily beat the market returns.
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Disadvantages of Index Mutual Funds
Index mutual funds can prove to be a great investment plan, no doubt. But it isn’t good to ignore the few drawbacks linked to this investment plan. Let us have a look-
The Index Mutual Fund tracks its benchmark index to ensure a similar return, which isn’t a simple task for sure.
A team of fund house takes numerous points into account for the perfect benchmark index tracking.
A big difference can be observed in the ultimate return value and the benchmark index return in the lack of accuracy.
In the Index Mutual Funds, the fund managers passively manage the portfolio. It means purchasing and holding an asset for the long term.
Meanwhile, an investor can’t buy and sell the assets due to numerous reasons.
In most instances, the index mutual fund may underperform if the expense ratio is high. The lower expense ratio of the index is a positive sign.
Things to Consider before Investing in Index Funds
Investment in Index Mutual Funds can prove to be a profitable decision. Still, there are a few essential rules that you must follow before proceeding.
Index funds track the benchmark funds; if the fund house team is experienced enough to execute this most critical step, these funds can act beyond your expectations.
Owing to this, the risk associated with market volatility and equity price fluctuations becomes easy to manage. Moreover, if one wishes to secure a highly profitable position, it’s possible in these funds.
But if the market is going through an extensive downturn, you may have to manage your portfolio actively.
That’s why it is always recommended to keep the mix of index funds together with actively-managed funds within a portfolio.
No wonder, the return is the most-admired factor among investors. Though, the return from Index Mutual Funds is relatively lower because of its actively-managed portfolio profile.
Actively managed portfolio can ensure a higher return. If safety is the major concern to you, of course, you should go ahead with this investment option. Index funds replicate their benchmark performance.
It doesn’t aim to beat the market return but to keep a secure profile of the portfolio. In most instances, the tracking errors can deliver unfavorable returns.
Hence, it’s always recommended to figure out the expertise of the fund house managers. The lower errors will offer accurate returns to the traders.
Typically, Index Mutual Funds comprise of a lower expense ratio. Still, the added fees can later shape into a burden for an investor. It will reduce the margin proportion.
So make sure you pick an investment plan with an expense ratio of 0.5% or less than it if you’re choosing a passively-managed index fund.
Actively managed index funds should have a 1% to 2.5% expense ratio. If it goes above that, don’t expect high from it.
Let us understand it better through an example. If two index funds are tracking a particular benchmark index, both indexes will generate similar returns.
The investment cost will be the only thing that will bring a drop in a particular index’s ultimate return value.
For instance, an index with a higher expense ratio will fail to outperform, whereas index with low expense ratio will generate a higher return.
Investors who have a long-term investment goal can find Index Mutual Fund an appropriate option.
For long-term purposes, investors invest in these funds. These funds are also used for a short term vision but it doesn’t make it that much profitable.
The price fluctuation and volatility can affect the performance of these funds on a short-term. That’s why if you expect higher returns of around 10% to 12%, stick to a long-term goal.
Only then you can get the full advantage of investment in the Index Mutual Funds.
Equity-oriented funds can be a great alternative if you wish to pile up extensive wealth for the future.
Such as, for your retirement planning index, mutual funds can prove to be a highly favourable option.
Tax on Gains
Though you shouldn’t fear about tax-related issues if you are investing in Index Mutual Funds, the low turnover of index mutual funds reduces higher tax issues.
Still, the taxation amount will depend upon your holding period. If you are planning to invest in the Index Fund with a short-term goal, you may invite higher tax of around 15%.
But if you are investing with a long-term vision, the capital gains will be taxed at 10%.
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Index Mutual Fund – Conclusion
Index Mutual Funds, also known as exchange-traded funds (ETFs), are a profitable and safest investment option for investors.
These mutual funds are passively managed, which ensures great returns at a minimal risk value. Still, most investors don’t agree on it.
They prefer investing in an actively-managed portfolio rather than passively managed portfolios, ignoring that the higher risk value can easily wipe out the entire invested amount.
But it doesn’t prove that index mutual fund is the best choice for all.
Before proceeding with the investment in such funds, it’s essential for every investor to figure out all the points that make this index fund an excellent option for them.
At few points, IMF can be a great investment option whilst at a few points it may not.
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