Index funds a good option for new investors

Index funds are for those investors who are not comfortable with stock picking and the idea of keeping a close watch on their portfolio. They can earn by simply putting their money in a fund that closely tracks key indices such as Sensex and Nifty.

An index fund gives the opportunity to buy stocks in the same proportion as their reference index. Theoretically, an index fund is an investment that tries to mirror the movement of the index of a specific financial market regardless of market conditions.

These funds have a tracking error i.e. difference between index and fund returns. Lower the tracking error better is the alignment of returns.

First time investors can opt for index funds as they have good
exposure to large-cap stocks and do not cause undue volatility. In recent times, the volatility in markets has made investors
cautious on direct exposure in equities.

The investors are realising the importance of passive investing strategy that attempts to reproduce or match the returns of an index.

Index funds save investors significant amount of money in annual fees compared with actively managed funds. Index funds are easier to create, manage and sell than the actively managed counterparts.

The good point about index funds is that the management expense ratio on these is lesser in comparison with the dynamically supervised mutual funds. Within index funds, a combination of low expenses and low tracking error will help in identifying good funds.

It has been noticed that several diversified funds have underperformed compared with index funds. The category average of diversified funds stood at 1.59% in one year, whereas S&P Nifty and BSE Sensex stood at 3.71% and 3.49%, respectively in one year ending July 20, 2011. The index funds category generated 3.32% returns in one year as on July 20, 2011.

From this, one will prefer to invest in index funds than in actively managed funds as this fund category has generated more returns than the actively managed funds.

According to experts, if an index fund outperforms its benchmark, then it can underperform the same later. The investor should go for the fund that closely maps the index. With index funds, portfolios are naturally diversified because the market itself is diversified. Therefore, there is less risk because not all of the investor’s eggs are in one basket.

Though index funds fetch low returns compared with diversified funds, but they fall less sharply during a downturn. There is less churning in the index fund portfolio. 

In short, you can just look at the index to know how your investments are performing.