Mutual Funds: How to leverage the potential of index funds in your portfolio? MintGenie explains

The dynamics of index funds have changed significantly in the last few years in India. With the proliferation of awareness initiatives and the introduction of innovative benchmark schemes by mutual fund houses, investors are exploring this universe with active interest. Simply put, index funds replicate a stock market index in terms of a portfolio.

For instance, if a mutual fund house were to launch a Nifty 50 Index Fund, it would have the same 50 stocks in its portfolio that are part of the Nifty 50 Index. Even the weightages of the stocks would mirror those in the index against which the scheme or the fund is benchmarked.

This means that these funds do not attempt to outperform the market but deliver in-line performance or match the returns of the benchmark. This is also the biggest difference vs active funds whose aim is to outperform the market at any given point of time or most of the time.

The role of index funds in your portfolio

Diversification & market representation: Index funds typically track a broad market index, providing inherent diversification across multiple stocks or assets. Therefore, an investor is invariably presented with a robust portfolio that is diversified across companies, sectors and market capitalizations, offering various opportunities. The broader market exposure extends to fixed-income indices as well that cover assets such as government securities, T-bills, corporate bonds, commercial papers etc.

Governed by the regulator to safeguard the best interests of the investors, these indices provide for a well-defined, market-relevant and rules-based framework. The difference between active and passive funds is generally in the percentage of exposure to sectors. While the index funds track sectors based on the benchmark, active funds could have more or less exposure than the benchmark to sectors.

Cost efficiency: The low-cost advantage of index funds can be an important feature, especially during volatile times. Since the underlying securities in the portfolio replicate the benchmark that it tracks, the fund manager is not actively involved in buying/selling of securities. Consequently, index funds have lower fees and operating expenses than actively managed funds. This works well for investors who are unsure of investing in mutual funds. In fact, index funds could turn out to be a way to gain exposure to markets for new /young investors.

Rebalancing: Index funds leverage market wisdom by following an automated and well-regulated investment method that is free from human or emotional bias. Since they mirror the asset allocation of the benchmark, the portfolio remains aligned with the index and reduces the need for frequent adjustment basis volatility.

Innovative opportunities: Stronger regulatory focus to develop the investing landscape in India coupled with the emergence of global themes has opened the floodgates for single or multi-factor thematic investments.

Transparency: With the ongoing volatility in the environment, investors are looking for transparency and resilience in addition to capital appreciation potential in their investment portfolios. Since index funds only allow for companies listed on a particular index to be a part of the portfolio, the investor knows the exact composition of the underlying assets in the fund. There is no communication barrier. Not only does this help in promoting transparency but also makes it easier for the investor to understand and track his/her portfolio.

As investors navigate the market volatility, the stability, passivity, and low-cost advantages of index funds have the potential to act like a beginner’s guide to investing. By reaffirming long-term financial goals and understanding the inherent benefits of index funds, investors can confidently emerge with a robust and resilient portfolio.

It would not be too hefty an assumption to dub index funds as the ‘silent winners’ of the mutual fund industry. With the multitude of options available at investor’s disposal, investors can choose to create a diversified portfolio for themselves that allows exposure to different indexes, sectors, themes, etc. and leverage market wisdom to tap into wealth creation opportunities. However, to conclude and offer a more holistic approach, we always believe in a diversified approach to investing where investors invest in both active and passive funds to complement their portfolios.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.

Ashwin Patni is Head Product & Alternatives, Axis AMC