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Beginner’s
guide to
Index
Funds
Investing in Index Funds
Using Mutual Funds, investors have two main investment strategies that
can be used to generate a return on their investments - Active portfolio
management and Passive portfolio management.
The first part highlights the difference between Active and Passive
Funds.
The second part discusses about Index funds and ETFs which come
under passive funds.
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The image below gives you an overall idea what this guide is all about.
Mutual
Funds
Active Passive
Funds Funds
Index
ETFs
Funds
How to
Invest?
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1. Active and Passive Funds
Active Funds are regular equity mutual funds, you are familiar with. It
is a mutual fund in which a portfolio manager makes decisions about how
to invest the fund's money. The fund manager buys and sells stocks
actively, in an attempt to make higher returns.
If the ABC fund’s 1 year returns is 10% and the NIFTY 50 returns is 12%,
the fund is said to have underperformed the benchmark index (2% lesser
returns). And vice-versa.
In other words, returns from active funds could be higher or lower than the
benchmark index, depending on the fund manager’s performance, the
fund’s expense ratios and so on.
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Note: Expense ratio plays an important role in active funds. It indicates
how much the fund charges in terms of percentage annually, to manage
your investment portfolio.
If you invest Rs. 20,000 in a fund which has an expense ratio of 2%, then it
means that you need to pay Rs. 400 to the fund in order to manage your
money.
If a fund returns equal to 15% and has an expense ratio of 2%, then you
would get a return equal to 13%. The Net Asset Value (NAV) of a fund is
reported after deducting all fees and expenses. But still, it is important to
know that how much are you paying to the fund.
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Passive Fund, as the name suggests, follows a passive investment
strategy – it just invests in an index. Its portfolio will reflect the
constituents of the index in their exact proportion in the index.
The performance of a passive fund will be that of the index it has been
benchmarked.
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Why choose Passive funds over Active funds?
The comparison table below gives you the key differences and why you
should choose Passive funds over active funds.
Key
Factors
Active Passive
Fund Manager risk High Low
The above table clearly indicates the advantages of passive investing over
active investing. Key factors supporting passive investing are – low cost, no
fund-manager-risk and simplicity. There shouldn’t be any doubt that
passive investing should be the first choice for new investors.
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2. Index Funds and Exchange Traded
Funds (ETFs)
Hope, investors are convinced of the fact that, why passive investing should
be the first choice for them. Let’s proceed to know how Index Funds and
ETFs help in using the passive investment strategy.
Before we read about Index Funds and ETFs, a short explanation about
what an Index is and how it works.
What's an Index?
The NIFTY 50 covers major sectors of the Indian economy and offers
investors exposure to the Indian market in one efficient portfolio.
Another popular index is the NIFTY Next 50, a collection of next-50 stocks
from NSE.
And similarly for Bombay Stock Exchange, the BSE 30 represents the top
30 stocks in the BSE.
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List of top NSE Indices.
Investors can invest in Index Funds of any the above indices, provided
there is an Index fund or ETF available.
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How do Index Funds work?
An index fund works a lot like a typical mutual fund. When an index fund
tracks a benchmark like the NIFTY 50 index, its portfolio will have the 50
stocks that comprise NIFTY, in the exact same proportions.
In an active mutual fund, the fund manager actively manages positions with
lot of buy and sells decisions, trying to maximize the returns for the
investor.
Whereas in an index fund the fund manager just buys the index stocks and
holds it. This can save investors a lot of money because there’s no frequent
buy and sell decisions.
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What's the difference between Index Funds and ETFs?
ETFs are Exchange traded funds of any Index, where their units are
traded on a stock exchange like NSE or BSE. Like shares of public
companies, they can be bought or sold anytime during the trading
hours of the stock exchanges.
What are the other factors involved in choosing Index Funds and
ETFs?
Cost
For buying or selling Index Funds, the transaction cost is zero. You usually
don't have to pay a commission or transaction charges to buy an index
fund, as they are sold directly by the mutual fund companies.
However, to buy ETFs you need an account with a stock broker. There are
other costs involved like impact cost, brokerage charges every time you buy
and sell units, DMAT charges, annual maintenance charges etc.
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SIP - Systematic Investment Plan
SIP is an easy and automated way to buy units at regular intervals and this
method can be used to buy Index Funds.
In case of ETFs, SIP cannot be done. The investor has to buy every month
regularly from the stock market, through his stock broker.
Expense ratio
As such, Index Funds typically have low expense ratio - the percentage of
assets paid to the mutual fund company. For example, UTI’s NIFTY 50 and
HDFC’s NIFTY Index Funds have an expense ratio of just 0.1%.
ETFs have lower expense ratio than Index Funds like 0.05%, but as the
transaction costs could be involved, the expense ratios for both could be
similar.
Tracking Error
Index Funds have a tracking error (like 0.1% in NIFTY 50), whereas ETFs
rarely have that error.
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Why choose Index Funds and not ETFs?
ETFs are no doubt an efficient to way to invest in Indices. ETFs are very
popular with US investors where are they are cost-effective as well as
convenient to invest.
But, in India ETFs are yet to reach retail investors in a big way.
Since ETF volumes traded in stock exchanges are low, investors find it
difficult to buy and sell them easily. Whereas one could buy an index fund
with ease and convenience.
Index Funds are cost effective, convenient and it’s possible to invest
systematically, making it the first choice for new investors.
Index funds are generally considered ideal core portfolio holdings for
retirement portfolio.
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Which Index funds to select?
The NIFTY 50 is the flagship index on the National Stock Exchange of India
Ltd and NIFTY Next 50 comes next. These 2 indices cover the top 100
companies traded in NSE India.
The investment decision in a mutual fund solely depends upon your risk
preferences and investment goals.
Once you have decided about your investment goals and how much to
invest, you can select the above two mentioned index funds.
New investors can consider investing in Nifty 50/ Nifty Next 50 or both in
50-50 ratio. Index funds have performed well over long term and have
offered inflation-beating returns, if invested for 10 years.
How to invest?
Many mutual fund houses like UTI, HDFC, Reliance, DSP, SBI, ICICI
and others offer index funds for the above indices.
The investors can choose NIFTY 50 Index Fund and NIFTY NEXT 50
Index Fund from any fund house of their choice, with low expense
ratio and low tracking error.
The investor can invest in Growth Fund – Direct option, directly from
the website of the mutual fund house.
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Index mutual funds are easy to understand and offer a relatively safe
approach to investing in broad segments of the market.
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This is a basic guide on Index Funds. There is nothing here which can’t be
found on the internet.
Just trying to make things easier for new Index Fund investors, especially
from Indian investors’ point of view.
Hope you would have found this guide useful. Please share it with your
friends.
In near future, hope to bring out a detailed guide about investing in ETFs
and other advanced Index products
Thank you!
For more news and updates on Index Funds and ETFs check out
https://www.twitter.com/indiaetfs
Disclaimer:
All of the information in this guide is for informational purposes only. The opinions in this document
should never be construed as specific investment advice or as recommendations to buy or sell any
securities. Conduct your own due diligence before making any financial or investment decisions.
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