An index fund is a type of mutual fund that replicates some index. The portfolio of the index fund will include the same stocks and in similar weights as the benchmark index. Indexing is passive form of if investing whereby the fund manager does not focus on stock picking or market timing. The opposite is active management whereby the fund manager will do in depth analysis and research to pick up stocks in the portfolio in order to beat the benchmark and generate higher returns.
Example of index funds: UTI Nifty Index Fund, HDFC India Sensex Fund, Motilal Nasdaq 100 FOF
Points to keep in mind before investing in Index Fund
1. Index fund usually have lower expense ratio (which translates to higher return). Since index fund managers are replicating the index, they do not require the services of research analysts and other analysts that are useful for stock picking and market timing
2. Index fund will always underperform the benchmark as the return on index fund is the return on index minus the management cost, transaction cost and commission.
3. They provide good diversification. You can get exposure to 50 companies by purchasing Nifty index fund
4. Index fund are classified as equity fund and are taxed at 15% for short term capital gain and 10% for long term capital gain
5. It is ideal for investors who has certain view on a sector or the economy. If you believe Indian economy is going to do well and don’t have the stock picking expertise you can buy the Nifty or Sensex India fund. Similarly if you believe US Tech or Indian Pharma is going to grow , you can take exposure by investing in respective benchmark fund
6. Investors who believe markets are efficient and active fund managers cannot beat the broad market returns can invest in these funds
7. Go to fund for investors with buy and hold strategy
Performance of Index fund
Index funds tend to outperform active funds in long run. However in short run, some managers do perform better than index funds. Active managers can manage downside risk better than an index better in a bear market.
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