All you need to know about index funds

All you need to know about index funds

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Diversify your portfolio, invest in an index fund. Get market-like returns at low cost.

TLDR Points

Index funds are the type of mutual fund whose portfolio is designed to mimic a market index and earn returns similar to the index. Here's why you should consider adding an index fund to your portfolio:

  • Low fund management cost as it is passively managed.
  • As the market index goes up, returns on the index fund go up in line with the underlying index.
  • Portfolio diversification as indices usually consist of a wide range of securities.

Introduction

Diversifying your portfolio is key to a good investment plan. Index funds are a great way to do that.

Here's a guide to index fund investment.

What are index funds

Index funds are designed to mirror an index such as the Sensex or the Nifty. So when you invest in this type of fund, the returns will be similar to that of Sensex and Nifty.

When you invest in an index fund, your portfolio will have the same components or securities that are present in the market index that the fund is tracking. This type of fund is passively managed, which also means the expense ratio to manage it will be lower.

Since these funds represent a broad market, an index fund investment is ideal for those who want to eschew individual stocks' risks.

How do index funds work?

To understand how to invest in an index fund, it is important to learn how index funds work. Let us take an example: You are investing in an index fund that mirrors the Nifty.

Nifty 50 is a stock market benchmark. The index is calculated as a weighted average of the top 50 stocks by market capitalisation in the National Stock Exchange and represents the country's stock market. So a Nifty 50 index fund will imitate this index. If Stock A has a 10% contribution in this index by market capitalisation, 10% of the portfolio your investment will go into is made up of Stock A.

Similarly, for Sensex, which is the weighted average by market capitalisation of the top 30 companies on the Bombay Stock Exchange, the index fund returns will imitate the Sensex 30.

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Features and benefits of index funds

Index funds are comparatively low on risk, and this makes them an excellent option for diversifying the investment portfolio. Some key features of an index fund investment are:

  • Index funds mirror a market index, and therefore the performance of the funds will be similar to the index that it is tracking
  • Index fund investment is a passively managed fund. This means that the fund manager is not taking any investment calls. The fund simply needs to be a replica of the index. As a result, the expense ratio is lower.

Here's what you must know

Like most things, there's a flip side to index fund investment. While a broader portfolio provides you with diversification, it may lower your return potential. Since the fund is passively managed, fund managers do not have the flexibility to take investment calls based on individual stocks' market conditions and performance.

Conclusion

Among equity funds, index funds carry lower risk and offer you a chance to invest in some of the best companies in the market at one go. Their lower expense ratio makes them even more attractive. However, other types of equity funds may be more suitable if you are looking for greater returns.

The digibank by DBS app makes index fund investment easy. Diversify your mutual fund portfolio now by downloading the digibank app.

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