Willing to diversify your portfolio? Index funds can be a great addition for predictable returns. let us brief. 

Diversification is a key element of a good investment portfolio. Investors try to spread their funds across various asset classes like equity, debt, real estate, gold, etc. Even within each asset class, they try to further diversify to minimize risks. In equity investing, a known method of reducing risks is diversifying your equity portfolio by investing in shares of companies from different sectors and of market capitalizations. This is where the Index Funds step in. Here, we will explore Index Funds and talk about the different types of index funds in India along with their benefits and a lot more.

How do index funds work?

As the name suggests, an Index Mutual Fund invests in stocks that imitate a stock market index like the NSE Nifty, BSE Sensex, etc. These are passively managed funds which means that the fund manager invests in the same securities as present in the underlying index in the same proportion and doesn’t change the portfolio composition. These funds endeavor to offer returns comparable to the index that they track.

Since Index Funds track a market index, the returns are approximately similar to those offered by the index. Hence, investors who prefer predictable returns and want to invest in the equity markets without taking a lot of risks prefer these funds. In an actively managed fund, the fund manager changes the composition of the portfolio based on his assessment of the possible performance of the underlying securities. This adds an element of risk to the portfolio. Since index funds are passively managed, such risks do not arise. However, the returns will not be far greater than those offered by the index. For investors seeking higher returns, actively managed equity funds are a better option.

Risks Associated with Index Funds 

No matter what kind of investments you are making risks are an integral part of it. An index fund will be subject to the same general risks as the securities in the index it tracks.

• Lack of Flexibility: An index fund is less flexible than a non-index fund as it reacts to price declines in the securities in the index.
• Tracking Error: An index fund may not perfectly track its index. For example, a fund may only invest in a sampling of the securities in the market index, in which case the fund’s performance may be less likely to match the index.
• Underperformance: An index fund underperform its index at times due to various reasons such as, fees and expenses, trading costs, and tracking error.

Before You Invest in Index Funds

Make sure to go through all the available information related to the fund the fund’s prospectus and most recent shareholder report. Enquire about the fees and expenses, specific risks associated with the funds, and most importantly, whether the fund's investment strategy aligns with your investment goals.