The Covid-19 pandemic has made us realize the need for saving and investing for a rainy day. While most of us were impacted financially in some way or the other, we can all agree on 2 things – multiple sources of income are extremely essential when things go sideways and you must not put all your eggs in one basket – your investments must be diversified.

But what do you do when each and every asset class is nose-diving and the entire economy is down? You invest in an instrument that will slowly recover along with the market. This is where an index fund comes in.

What is an Index Fund?

An Index Fund is a type of mutual fund, whose portfolio replicates that of an index. What is an index you may ask? An index is a benchmark that represents a group of companies that define a particular market segment. For example, the Nifty 50 Index represents the 50 largest companies listed on the National Stock Exchange. Few of the popular indices in India are the Sensex, Nifty 50 and Nifty Next 50 indices.

While most mutual funds aim to beat the benchmark index and provide higher returns, the aim of Index funds is to provide returns as close to that of the benchmark index.

How does an Index Fund work?

Index funds invest in companies in the same weightage, as that in the underlying index. Let’s take the example of a Sensex Index Fund. The Sensex comprises of 30 well-established and financially sound companies. Now, a Sensex Index Fund will also invest in these 30 companies that make up the Sensex. The holding in each of these 30 companies will be the same as the weightage of each company in the index.

If you hear the word ‘tracking error’ when it comes to Index Funds, do not worry. Put simply tracking error is the slight difference between the returns from the index and the returns from the Index fund. While Index Funds replicate the portfolio of the underlying index, the performance is not exactly the same and the slight difference between the two is because of the strategy and actions of the fund manager. It is the fund manager’s responsibility to reduce the tracking error.

Should I invest in an Index Fund?

Low management expenses – Since the Index Fund is a passively managed fund and is simply imitating an index, the management expenses for managing the index fund are lower than that of actively managed equity funds.

While assessing an index fund, look for the expense ratio – and keep in mind a lower expense ratio in an index fund is better.

1. Less Risky - Index funds are less risky compared to other equity mutual funds and hence a good starting point if you want to start investing in mutual funds. Hence they are ideal for the buy and hold investment strategy.

2. Does not ‘beat the market’ – Many investors focus on high returns and aim to invest so as to earn returns over and above what the benchmark index will give. However, the aim of investing in an index fund is to neither outperform nor underperform the index but move along with it.

When should you invest in an Index Fund?

1. First-time investor – If you are a conservative investor who wants to dip her feet into the equity markets or get some experience in investing in mutual funds, Index Funds are a great option for long term investing.

2. Economy is recovering - Since Index Funds imitate a benchmark index that is made up of the 30 -50 top companies in the market, it is more likely that when the economy is coming out of a slump and slowly recovering, the top companies will start faring well first. Thus in such situations by investing in an index fund you will ride the upward trend.

Bottom Line

Index funds are ideal to get a first-hand experience of investing in mutual funds without taking big risks. While selecting an index fund, opt for one that has a low expense ratio and a low tracking error.

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This article is written by Namrata Patel for Basis

Basis is a first-of-its-kind platform, aimed at enabling women to achieve financial independence through expert advice, in-app knowledge Boosters and supportive communities.