Your First Brush With Mutual Funds: Index Funds

<div><em><strong>Sunil Dhawan</strong> explains how your index fund can be your friend for the long road with less bumpy ride</em><br><br><br>An index fund is similar to any other diversified equity fund but with a small difference yet yielding a big impact.</div><div>&nbsp;</div><div>Index mutual funds remains the most ignored category amongst investment choices. The primary reason for that could be the passive approach to investment that it inherently follows. For those looking to have a flavour of the markets and investing in general, index funds fits the bill. Beginners to mutual funds investing who could be students, those in their mid-forties or even those nearing retirement, can consider index funds especially if it’s their first brush with mutual funds. They are less volatile than their other counterparts-diversified funds.</div><div>&nbsp;</div><div>The fund manager of index fund has no say in stock selection because the portfolio of index fund mirrors that of the index. So, an index fund benchmarking the BSE Sensex will only hold those stocks and that too in the same proportion as they are in the index. There is no active fund management involved in index funds.&nbsp;</div><div>&nbsp;</div><div>Because of this correlation, the NAV of an index fund moves virtually in line with the index it tracks. For instance, if the Sensex rises 10 per cent in a month, the NAV of a index fund linked to it, will also roughly appreciate 10 per cent over the same period. If the Sensex drops 10 per cent, so will the NAV of the index fund.&nbsp;</div><div>&nbsp;</div><div><br><img alt="" src="http://bw-image.s3.amazonaws.com/graph-lrg (1).jpg" style="width: 607px; height: 199px; margin: 1px;"><br><br>While looking and comparing various index funds, an important element is the ‘tracking error’ of such funds. Even though, index funds aim to mirror market movement, the returns are actually marginally lower than the index they track. This variation is termed as ‘tracking error’, and occurs due to various costs an index fund has to bear such as brokerage, marketing expenses and management fees. The lower the tracking error, the better is the fund.&nbsp;</div><div>Over longer term, say 7-10-15 years, actively traded equity diversified mutual funds often fail to beat market. Whether markets are on the slide down or going up, active fund managers have a tough job making the right calls. Once a while, their decisions may work and their stock picks could become market favorite. Over longer periods, across different market cycles and economic conditions, ending up on the right side is always a difficult thing to achieve. Returns from index fund can be expected to be in line with that of the markets, no matter what the time horizon is. The winner mutual funds scheme of today may not be the winner tomorrow or 10-years from now. Your index fund can be your friend for the long road with less bumpy ride.</div><div>&nbsp;</div>