Mutual Fund tips and tricks: What is Index Fund? How to invest?

We all are familiar with mutual fund investment which can be done with several options, including index funds. Just like large cap or mid cap funds, index fund is also a subcategory of mutual funds. Index funds are passively managed funds which track the composition of benchmark indices like Nifty 50, BSE Sensex, etc. This form of investment differs from an actively managed fund, on which calls are taken by fund manager actively such as providing overweight or underweight position on stocks and sectors based on various research. 

Experts at Paytm Money say that active fund managers work hard to potentially help you make more money on your investment. But at the same time, they are also going to charge you more, hence a relatively higher expense ratio. On the other hand, the Index Fund manager has to imitate the composition of stocks in the underlying index and hence chare a relatively lower expense ratio.

Passive investing platform are gaining popularity on Dalal Street with large cap funds struggling to beat their benchmarks. Hence, index funds are now seen as another tool for hedging gains by investors. 

What do Index Funds eye? 

According to Paytm Money, aim of an Index Fund is to track as closely as possible the performance of the underlying index. For example, a Nifty 50 Index Fund will invest in stocks comprising the Nifty 50 index in the same proportion as in the index. The fund attempts to achieve returns equivalent to the Nifty 50 index by minimizing the performance difference between the benchmark index and the fund (known as tracking error).

Two important parameters to consider while investing in index funds are, as per Paytm Money. 

Expense Ratio (ER):

As per Paytm, Index funds are low expense products compared to actively managed funds. There is no scope for outperforming the benchmark. The difference between benchmark and index fund returns majorly arises due to expense ratio.

Consider a Nifty 50 index fund (that tracks Nifty 50 benchmark index). The benchmark index is assumed to give a 6.00% return in the past 1 year. Take a look at the returns given by the index fund for different ERs.

Thus you should prefer index funds that have a lower expense ratio (scenario 3).

Tracking Error (TE):

Tracking error is a statistical parameter that tries to capture the level of deviation between the index fund return and benchmark index return. TE measures how good the fund manager is in tracking the underlying benchmark index performance. There are multiple sources of TE such as maintaining cash in the fund to handle redemption, time lag between benchmark index rebalancing and index fund rebalancing and so on.

As an investor, what is important is to look for funds with lesser Tracking Error. A lesser tracking error means that the index fund tracks the benchmark index closely. Remember, this is the basic aim of an Index Fund!

Hence, while investing in index funds you must know that lower the expense ratio and tracking error, the better return you will earn from investing in this mutual fund category.