Index Funds: Everything To Know About Passive Investing For New Investors
In simple terms, investing is the act of allocating funds to an investment scheme. There are two types of investment options when it comes to allocating funds to mutual funds. Those two options are passive investing and active investing. Under an active investing strategy, the fund manager attempts to optimise returns by continuously buying and selling off assets. In this strategy, the fund manager invests continuously and then, regularly monitors their performance to earn profit. On the other hand, passive investing is an investment strategy where you can maximise your income. This is made possible by minimising your purchase and sale. Broadly, passive investing refers to a portfolio strategy known as buy-and-hold. Passive investing is done for long-term investment horizons, with minimal trading in the market involved. One of the alluring features of this strategy is that it is considered cheaper and less complex. Moreover, as time passes by, it may produce after-tax results.
One of the goals of passive investing is to generate wealth gradually. Passive investors don’t seek profits from things like short-term price fluctuations or market timing. This strategy functions with the underlying assumption that the market will yield positive results over time. investors following this strategy try either to match market or sector performance. They attempt to replicate the market performance by creating a well-diversified mutual fund portfolio of single stocks. This investing strategy tries to avoid things like fees. There are two types of mutual fund variants that follow this investment strategy. They are: exchange-traded funds (ETF) and index funds.
What are index funds?
This variant of a mutual fund scheme attempts to imitate the portfolio of a certain index. Also known as index-tracked mutual funds, the main aim of these passively managed funds is to both match and track the performance of a popular stock market index like NSE NIFTY 50 and BSE Sensex.
The strategy for asset allocation followed in this variant of mutual funds is the same as that of its underlying index. The strategy is the reason why the revenue earned by investing in index funds is comparable with their underlying index. Just like it is the case in mutual funds, in an index mutual fund, your money is pooled with other investors by an AMC. Once enough wealth is collected, the fund manager allocates them to different indices such as stocks and bonds. In an index fund, the fund manager may or may not choose to allocate funds to every component of an index. The main aim of these funds is to get an appropriate sample of every index. By getting an appropriate sample of every asset, a fund manager can effectively track index performance over time.
How do index funds work?
A collection of securities that define a particular market segment is called an index. As these mutual funds are known for tracking a specific index, they come under the passive fund management category. In this passively managed fund, traded securities are deeply dependent on the performance of the underlying benchmark. Furthermore, one of the major benefits of passively managed funds is that they do not require a team of research analysts to analyse market movements and pick the most-suited stock. In contrast to actively managed funds that try to time and beat the market, an index fund is designed in terms of performance that matches the performance of its index. The returns on index funds are aligned to the underlying market index.
Are there any benefits of allocating funds to index funds?
Listed below are some of the advantages of investing in index funds:
- They come with tax benefits:
Index mutual funds are known for frequently generating a low turnover for the investors, i.e., it is referred to as low turnover Whenever a fund manager places very few trades in a year. Fewer trades are known for resulting in fewer capital gains distributions being passed on to the unitholders, thereby resulting in the reduction of taxes.
- They don’t come with exorbitant fees:
As stated earlier, in index funds, there is no requirement for a team of research analysts. Generally, research analysts are the professionals who can help fund managers to choose the right stocks. Also, no active trading of stocks is involved in these funds. These factors are known for resulting in the low managing cost of an index fund. If you are seeking an option that doesn’t come with a huge fee, then, index funds might be an ideal option.
- They are easy to manage:
A popular advantage of index funds is that these type of mutual funds can be managed easily. That’s because the portfolio manager need not worry about how the index stocks are performing in the market. All that’s required of a fund manager is to periodically rebalance the portfolio.
The stocks of index mutual funds are known for belonging to well-established businesses. Therefore, they are not affected much by the market fluctuations. Investing in well-established companies ensures that you can enjoy a stable income consistently.