Choosing an Index Fund to invest In – Here are Valuable Tips

Published On: 24-Mar-2020

When one chooses to invest in equity markets, BSE Sensex and Nifty 50 are the two most familiar words for the investors. These are the name of two major stock indices in the country – BSE Sensex and Nifty 50. Since such indices are constructed using scientific methodologies and back-tested techniques, retail investors may prefer to have investment exposure in such indices. However, one cannot invest in such indices directly as they are not a security within themselves, but just an index of different securities. 

An investor thus needs to invest in several stocks in a similar proportion, like that in the index to construct a similar investment portfolio. However, this would also call for constant monitoring of the index composition, and periodic rebalancing of the portfolio. This entails not only higher transaction costs, but also higher capital investment to create a similar investment portfolio. Alternatively, investing in Index funds is a more convenient option, as they allow investors to have investment exposure in broader market indices. 

An index fund is a fund following a passive investment strategy that replicates a specific index in its investment portfolio. Since the fund manager completely mirrors the portfolio composition of the broader market index, the returns will also be similar to that of the index being tracked. As such, the investors should not expect any outperformance from the market, as an index fund will not generate any alpha. For example, if BSE Sensex generates 10% returns over the last year, a Sensex based Index Fund can also be expected to generate such returns for the investors. Such returns will, however, be subject to the tracking error and fund expenses. 

Choosing an Index Fund

Here are three primary factors that investors must consider while selecting an index fund to invest:

Underlying Index

While one may not differentiate two index funds tracking the same index, two index funds tracking two different indices may offer different risk exposures for the investors. For example, an index fund tracking Nifty Next50 (market index composed of midcap companies) will be more suitable for aggressive investors as compared to an index fund tracking Nifty50. As such, one may select the index fund, which suits the investor’s risk profile and return expectations.

Tracking Error

While a fund manager may not have any flexibility in terms of designing an investment portfolio, the index composition must be continuously monitored for any changes/ rebalancing so that appropriate changes can also be made in the fund portfolio. This is to ensure that the fund portfolio continues to mirror the underlying index at all times. 

Tracking error refers to the timing difference of the changes in the index, and the time when changes are mirrored in the index fund. The tracking error can be gauged from the scheme returns when compared against the benchmark returns, as the only difference between the fund returns and benchmark returns would be that of the tracking error and the fund expenses. An investor must always prefer an index fund with lower tracking error, as the main aim to invest in index funds is to replicate the returns of the benchmark indices itself.  

Total Expense Ratio (TER)

TER refers to the annual fund expenses that are charged to the scheme. As such, the investors may prefer such funds that have lower TER as against other funds. However, it must also be noted that since the TER of index funds is already lower, any relative difference between TER of two index funds may be minimal and may not significantly impact the selection of index funds. 

With the above considerations, the investors can make an informed decision about selecting the right index fund for them to invest their money.