Must know the Benefits and Drawbacks of Index Funds

James J. Latham
10 Best Index Funds In April 2022 | Bankrate

In India, passive investment is gaining popularity. Today, many investors believe that investing in an index fund or exchange-traded fund (ETF) is the most cost-effective and hassle-free way to build long-term wealth. Many investors in India appear to have been convinced of the invincibility of the passive strategy by the performance of large-cap index funds and ETFs over the last two years.

Many actively-managed large-cap schemes have suffered in recent years, while their passively-managed rivals have outperformed them. Mutual fund managers and advisors, on the other hand, point out that the result is due to the stock market’s narrow rally. However, many investment professionals predict that active funds will struggle to outperform their benchmark in the future years.

According to these advisers, several actively managed funds, particularly in the multi-cap, midcap, and smallcap divisions, continue to outperform their benchmark by a substantial margin. Many funds, they feel, will be able to create alpha or outperform their benchmark in India for at least a decade. 

Benefits of Index Funds

Low Risk and Steady Growth

Index funds are relatively low-risk investments in equities and bonds that are geared for consistent, long-term growth. They are naturally diversified, covering various industries inside an index, protecting against large losses. Index funds also outperform the bulk of non-index funds that try to outperform the market.

Low Fees

Investors can save money by investing in index funds rather than non-index funds. Even if non-index funds outperform index funds, it might outperform them by a specific margin to earn returns that cover its expenses. 

One explanation for the higher costs is that actively managed funds have a lot more transactions than index funds, which are less actively traded because they follow an index. 

Market exposure is broad

The investment portfolio is diversified across all sectors and stocks when money is invested in a proportion equivalent to an index. As a result, an investor can use a single index fund to capture the likely returns on a bigger part of the market. For instance, if you invest in the Nifty index fund, you will gain exposure to 50 firms distributed over 13 industries, ranging from pharmaceuticals to financial services.

Investing in Index Funds Has Tax Benefits

Because index funds are passively managed, they often have a low turnover or a small number of trades made by fund management each year. Because there are fewer trades, there are fewer capital gains distributions to unitholders.

It’s a lot easier to manage

Index funds are easier to manage since fund managers don’t have to worry about how the index’s stocks perform in the market. All a fund manager has to do is rebalance the investment portfolio regularly.

Drawbacks of Index funds

Flexibility is lacking

Index fund managers have much less flexibility than managed fund managers since they must adhere to policies and procedures which force them to follow an index’s performance. Investment decisions in index funds must be made within the constraints of matching index returns.

Index fund managers, for instance, have few options for reducing losses if an index’s returns are rapidly declining. Actively managed fund managers, on the other hand, have far more flexibility to act in good and bad times to find better-performing solutions.

No significant gains

Unlike managed funds, index funds does not have the ability to outperform the market, which means that investing in an index fund means preceding the chance of a large profit. In a given year, the top-performing non-index funds outperform the top-performing index funds, and the very best non-index funds can outperform an index fund in a single year. 

Non-index funds’ top performers, on the other hand, might fluctuate from year to year, allowing under-performing years to cancel out over-performing years. In contrast, index funds’ performance is more consistent.

Final Thoughts

Index funds are perfect for those who do not want to take any risks with their short-term investments due to market volatility. They are also a superior option if you cannot select high-quality equity mutual fund strategies.

Thus, there are some appealing advantages to index funds, but there are also some disadvantages to consider. Before you invest, learn what an index fund is and isn’t.

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