These funds are considered as a cost-effective investment option as they have ability to provide index-linked returns at a lower cost.
To track the market movements correctly, fund manager is required to hold all the securities in same proportion as in the index.
Index fund are also known as passively managed mutual funds because the fund manager of each index fund imitates the index, rather than trading securities separately in the market.
These funds allow you to invest in specific sectors and to invest in both growth and value stocks, giving you maximum diversification. Investors who want to invest in equities at a very low cost can go for Index Funds.
Things to consider before investing in Index Funds:
There are two important things to consider before investing in an index fund: Tracking Error and Expense Ratio.
Tracking Error: Tracking Error is the standard deviation of the returns differential between the fund and its benchmark. Index funds must mimic market returns as both under-performance or out-performance as against the index is considered as a 'tracking error'. The idea is always invest in an index fund with the minimum tracking error.
Expense Ratio: Expense ratio is the management fee stated as a percentage of assets managed i.e. the lower the ratio the better the fund is. Index funds have an expense ratio ranging between 0.75% and 1.5%. Suppose a person invests Rs 1 lakh for a period of five years in a fund that has an expense ratio of 0.75% and expects to earn 15% return every year.
The total cost of holding the fund for five years will be Rs 7,430. If the expense ratio is 1.5%, the total cost increases to Rs 14,639.
The optimal index fund is one which has low tracking error and expense ratio.
Flaws with Index Funds:
As index funds are designed to replicate the index, they must match the returns of the index rather than under-performing the target index. But the cost of trading stocks to adjust equity proportions on the same lines of an index, ensures that the index fund under-performs the index.