Index funds are mutual funds that are passively managed. While they do have a fund manager, there is no deliberate stock analysis and picking since index funds track an underlying benchmark index. For instance, a Nifty 50 index fund will have the same composition as the Nifty 50 index.
The reason why many investors are starting to invest in index funds is that index funds are a high-diversification, low-cost solution for your investment portfolio. Since they are passively managed, their expense ratio tends to be lower than actively managed funds. Another point to note here is that since index funds mimic a broad-based market index, they tend to outperform the market as a whole in the long run.
If you are looking to buy index funds, then here is what you need to know.
How to select an index fund
When looking at different index funds, here are a few things to look into to make a better investment decision:
- The benchmark index is the first thing you should check as well as the composition and primary holdings of the index fund.
- Also look at the fund manager of the index fund and their experience. You can also check the other schemes that they manage.
- Another thing to look into is the index fund’s tracking error. Even though every index fund tries to track its benchmark index closely, it may not always be able to do so. You want to invest in an index fund that has a minimal tracking error.
- Go over the basics such as the Assets Under Management (AUM) of the fund, its current Net Asset Value (NAV), how long it has been since its inception, and the fund’s objective.
- Check the fund’s indicative investment horizon and the scheme’s risk level individually and in comparison to its benchmark index.
- Look at its rate of return over the last one month, one year, three years, and five years. While past performance is not indicative of the fund’s future performance, these are still important numbers to look at.
- Check the index fund’s total expense ratio as well as important risk ratios such as beta, Sharpe ratio, and r-squared.
How to buy index funds
The process of buying index funds is the same as other mutual funds. You can buy them directly from the official website of the Asset Management Company (AMC) or you can buy the fund through an intermediary such as a distributor, broker, or advisor. The first option is cheaper, quicker, and more convenient if you already have a fair idea of what you are looking for in an index fund. In that case, the process is as follows:
- Go to the website of your preferred AMC.
- Create an account with your details such as name, email address, and phone number.
- Go through their index fund schemes and choose the one you want to invest in.
- You will be shown two ways in which you can choose to invest in the index fund – lumpsum and Systematic Investment Plan (SIP). Select the one you prefer.
- If you choose the SIP option, you will then have to select your SIP amount and frequency. For most index funds the minimum SIP amount is Rs 1000.
- After you have selected all these scheme-specific details, you will have to complete your eKYC for which you will need your Aadhaar card, phone number linked with your Aadhaar card, PAN, and a copy of a canceled cheque with your name on it.
When you invest in an index fund after knowing which segment of the market you want to track, it can prove to be a beneficial investment for you in the long term. For instance, if you want exposure to the small-cap market segment for its significant growth potential, then investing in a small-cap index fund will be beneficial. Hence, the first thing you need to do is figure out what kind of broad-based market index or segment you want to target and then look at index mutual funds based on that.