People invest in mutual funds with a singular purpose. The said purpose is to acquire wealth in the long term. The wealth might be useful for people to take care of their day-to-day expenses after retiring. So, one thing to remember about a decision to opt for an investment in mutual funds is that it is a long-time commitment. But there are some things that you need to remember about mutual funds. One of those things is that they are not a monolith. There are different variants of mutual fund schemes that are available in the market as an investment option.
One of these different types of mutual funds is index funds. A prominent example of passive investing, index funds is known for working in firm contrast to mutual funds that are actively managed.
What are index funds?
Index mutual funds are a type of mutual fund scheme that is known for coming with a portfolio that’s constructed either to match or track the components of a financial market index. Index funds are known for providing an investor with features like low portfolio turnover and low operating expenses. These funds are known for following their benchmark index regardless of the state of the markets.
Are there any key features of index funds?
Listed below are some of the key features of index funds:
- Index mutual funds are known for consisting of a portfolio of stocks. These are the stocks that are designed to mirror the composition and performance of a financial market index.
- Amongst the salient features of Index funds are their lower fees and expenditures.
- Index funds are known for trying to match the risk and the income of the benchmark index. Index fund investments are carried out based on the theory that as time passes, the market will outperform any single investment.
How do they work?
A collection of different securities that define a particular market segment is referred to as an index. Because index mutual funds track a particular index, they can be considered an example of passive fund management. Under passively managed funds, the performance of securities traded is linked to that of the underlying benchmark. Additionally, passively managed funds are known for coming with another major advantage. Mutual funds that follow passive investing do not require a team of research analysts to identify opportunities and then pick the most-suited stock.
Factors to consider before opting for index funds:
Before signing up for an index fund and then allocating a portion of your money for paying for the investments, you must select the investment scheme that comes with minimum tracking error. As these funds are known for replicating the performance of an underlying index, sometimes, you may notice a slight deviation from the returns offered by the index. This can be defined as a tracking error. In case you have a lower tracking error, it is indicative of better fund performance.
- Expense ratio:
It is important to opt for an index fund that comes with a lower expense ratio as it might deliver higher returns. Index funds are known for having a lower expense ratio, in contrast, to actively managed funds. That’s because, for an index fund portfolio, a fund manager is not required to formulate an investment strategy.
- Investment horizon:
An index fund is suitable for investors who have a long-term investment horizon in their minds. For short-term investments, the fund may experience fluctuations. So, one must invest in these funds for at least 7 years to expect good returns ranging between 10 to 12%. Hence, only when you invest for a long time, the fund has a chance of performing to its full potential.
Apart from the three above, there are several other factors you need to remember about investing in index funds. In case you are having doubts about the compatibility of index funds with your financial goals, consult a financial expert.