Index funds: How are they different from other mutual funds?

Retail investors are constantly searching for schemes that are efficient enough to offer them diversification and long term gains. Mutual fund investors usually invest across equity and debt to ensure that they have a well-diversified equity portfolio. Mutual funds can be largely categorized as active and passive funds. Most of us invest in actively managed funds like ELSS, liquid fund, etc. where the fund manager plays a poignant role in buying and selling securities in quantum with the scheme’s investment objective. And there are passive funds like index funds that aim at generating capital appreciation by predominantly investing a particular underlying index for example NIFTY 50, BSE 100 etc. As per SEBI guidelines, an index fund must invest a minimum of 95 percent of its total assets in its underlying index.

What are index funds?

As stated earlier, index funds aim at generating capital appreciation over the long term by mimicking the performance of its underlying benchmark with minimal tracking error. Index funds too have fund managers, but here the duty of the fund manager is to evaluate, and reshuffle stocks based on the scheme’s response to its existing underlying securities. Since it is impossible for the fund manager to invest in all the securities of a particular index, the index fund can might not be able to appropriately replicate the performance of its underlying benchmark.

How are index funds different from mutual funds?

Although both index funds and mutual fund schemes are similar in many ways, there is one big difference between them. While most mutual funds are actively managed, index funds follow a passive investment strategy. Here, the fund manager isn’t actively involved in buying or selling stocks on a regular basis. But instead, they pick stocks of a particular index and build a portfolio of securities that try and mimic the performance of their underlying benchmark with minimal tracking error. Mutual funds on the other hand aim at generating capital appreciation over the long term by investing in a diversified portfolio of underlying securities

Benefits of investing in index funds

Low expense ratio

Since there is no direct participation of the fund manager in helping the scheme outperform its underlying benchmark, the expense ratio of an index fund is lesser than other actively managed funds. Investing in a scheme with a low expense ratio can be a good idea since it will not affect your long term capital gains.

Free of human error

Index funds mimic the performance of their underlying benchmark. They work on a predefined algorithm which means that the performance of the scheme will not get affected by human biasness. Also, chance for human error is very low and if you are looking for a scheme that is purely working on a predefined investment strategy, you can consider investing in index funds.

Ideal for long term investors

Over the long term index funds are generally outperformed their underlying benchmarks and hence are ideal for investors with an investment horizon of minimum seven to ten years. Since these are equity oriented schemes that track the performance of market indices, index funds should be given their own space and time to show their true potential. Investors can target their life’s long term financial goals like building a retirement corpus or building a corpus for their daughter’s wedding or any financial goal that requires systematic long term investing.

Investors can also consider starting a monthly SIP in an index fund scheme of their choice. SIPs ensure that you save an invest a fixed amount at regular intervals and continue investing till your investment objective is accomplished.

Written by 

Alex Wilson: Alex, a former tech industry executive, writes about the intersection of business and technology, covering everything from AI to digital transformation.