19th October 2021
Finance

What are some of the risks associated with index funds?

Mutual funds are further categorized depending on their various attributes like fund size, asset allocation strategy, investment objective, market cap, risk profile etc. Mutual fund investors generally prefer diversifying their portfolio across various asset classes to ensure that they are able to get the best out of all asset classes.

Some of the major mutual fund categories include equity, debt, hybrid, solution oriented, gold, ETFs, and index funds. Mutual funds can be largely categorized as actively managed funds and passively managed funds. Actively managed funds are open ended mutual fund schemes which involve active participation of the fund manager. Here, the fund manager is responsible for building a diversified portfolio and at the same time ensuring that he / she strategically buys or sells securities to help the scheme achieve its investment objective. Passively managed funds on the other hands do not involved active participation of the fund manager.

What are index funds?

Index funds are such passively managed funds which aim at generating capital appreciation over the long term by tracking their underlying benchmark / index with minimum tracking error. Every mutual fund scheme has an underlying benchmark which it aims at outperforming over a stipulated period of time. An index fund closely corresponds to its underlying index which can very from scheme to scheme. A market index represents the performance a basket of securities. Some direct examples of market index are NIFTY and SENSEX. and since you cannot directly invest in a market index, you can do so by investing in an index funds. The investment objective of an index fund is simple, to match the capital appreciation offered by its underlying benchmark with minimal track error.

Benefits of investing in index funds

Here are some of the primary benefits of investing in an index fund –

Low expense ratio – Every mutual fund scheme has recurring costs such as management fees which are recovered by the fund house in the form of expense ratio. Since passively managed funds do not involve active participation of the fund manager, the expense ratio of owning a passively managed fund is always low compared to actively managed fund. As stated earlier, index funds track underlying benchmarks, thus requiring very less input from fund managers. This allows cost cutting which allows the fund house to levy a low expense ratio on the passively managed schemes like index funds. A low expense ratio will ensure that a small percentage of your capital gains is cut when you liquidate your index fund units.

Target long term goals – Investors can target their life’s long term financial goals like building a corpus for their sunset years, securing their child’s financial future, buying their dream home and similar goals. Since index funds are equity heavy schemes, it is essential to have a long term investment horizon to ensure that the scheme is able to perform to its fullest potential. It is ideal to remain invested in index funds for a minimum period of seven to ten years.

Common risks associated with index funds

Index funds can help investors earn decent returns when the markets are performing. But during volatile market conditions your index fund portfolio can get affected and you may even have to face short term losses. Not every index fund is able to properly track its underlying index. Tracking error can cost investors big time. Index funds carry low flexibility as compared of actively managed equity funds where the fund manager can change the asset allocation strategy depending on market fluctuations. If the index underperforms the index fund too will underperform, and this is an uncontrollable factor.