To build a rewarding mutual fund portfolio, it is important for investors to diversify their investments across markets and asset classes. Some of the most common assets which investors consider for diversification are equity, gold, debt, and real estate. What’s amazing is that even under each of these asset classes, there are further possibilities to mitigate the overall investment risk by investing in different subcategories. Under the equity gamut, one way to minimize investment risk is investing in market linked schemes like equity funds that invest in a basket of securities of companies belonging to various sectors and industries.

While most equity funds are actively managed, index funds offer passive investing for those who want to invest in a scheme whose portfolio is void of biased human involvement. Let us find out more about index funds and whether they are ideal for your financial goals.

What is an index fund?

An index fund is a mutual fund scheme that invests in stocks belonging to a specific index. The index fund is designed to replicate the performance of the securities of its underlying benchmark while generating returns. While active funds try to outperform their benchmark, index funds try to generate returns similar to their benchmark.

Important things to know about index funds

How do index funds work?

Index funds only invest in stocks belonging to a particular index like the NIFTY 50 or SENSEX 30. So, if an index fund invests in SENSEX 30 index, it will try to replicate the performance of these 30 stocks the way they have performed at the index. This way, the index fund has minimum human involvement, and the returns are free from human errors too.

Index funds have a low expense ratio

By now we have established the fact that index funds try to generate returns similar to the stocks of their underlying index/benchmark. This is different from the active style of mutual fund investing where the fund manager is involved in actively buying and selling securities from the scheme’s portfolio and ensures that he maintains a well-diversified portfolio. Since other mutual funds have active involvement from the management end, they have a high expense ratio as opposed to passive funds like index funds that have a low expense ratio.

Ideal for passive investors

Not all investors want their portfolios to be actively managed by fund managers. In fact, some investors are not sure about the fund manager’s ability to generate returns from lucrative market conditions. Such investors who do not wish their portfolios to be reshuffled from time to time can consider investing in index funds. Index funds follow a passive investment strategy and although they too have a dedicated fund manager, he/she has very little say in how the fund generates returns from time to time.

Ideal for investors with a long term investment time horizon

Since index funds are mutual fund schemes that heavily invest in the equity market, one cannot expect them to generate returns every day. Investors need to have patience and give their investment a minimum time of 3 to 5 years so that the scheme is able to perform to its fullest potential. Since the stock market is highly volatile in nature, investors can even witness negative returns in the short run, however, in the long run, they might be able to generate a commendable corpus is they continue their investment journey in a disciplined manner throughout the investment horizon.