Investing isn’t a one-size-fits-all prospect, especially given the volatile and unpredictable nature of the market. Each investor takes a different approach to investing according to their age, income, risk appetite, current finances, and goals. Some investors prefer active investing strategies and invest in stocks with high-performance potential, while others opt for a more passive approach through investment in index funds.

An index fund is a type of mutual fund that aims to track the performance of a specific market index, such as the Nifty or Sensex. By mirroring the composition of the chosen index, these funds enable investors to mimic the returns of the broader market with minimal effort. However, just like any other investment vehicle, index funds also have certain advantages and associated risks that should be carefully considered. Here is what you need to know. 

Benefits of investing in index funds 

Diversification and risk management

Investing in a broad-based index fund, like one tracking NIFTY 100, ensures that an investor has exposure to several businesses across various industries. With a single investment, an investor achieves diversification which further protects the portfolio from fluctuations in a particular company or industry. This is especially beneficial for beginner investors who may not have the knowledge and experience to analyse and create a well-diversified portfolio independently.

Low costs

Since index funds don’t require active management, their costs are significantly lower than those of actively managed funds. This means more of your money works for you and potentially generates higher returns over time.

Passive management

With index funds, the need for constant monitoring of individual stocks and making swift decisions based on market fluctuations is eliminated. This allows investors to adopt a buy-and-hold strategy with diminished stress and time spent on managing their investments. This empowers investors to focus their time and energy to other critical financial decisions, all while maintaining long-term growth.

You can invest in index funds with limited capital via an SIP

By using the SIP method to invest in index funds, you can make small investments at regular intervals and grow your portfolio. AnSIP investment also leverages rupee cost averaging, which means you buy more units during bear markets and fewer units during bull markets. This method eliminates the need for market timing, as it focuses on long-term investment growth rather than attempting to predict short-term fluctuations.

Furthermore, by setting up an automatic payment plan for your SIP, you can stay committed to your investment in mutual funds while benefiting from the power of compounding. 

Risk associated with index funds 

Limited flexibility for investors to make portfolio adjustments

The investment strategy of index funds is to follow a specific index, meaning that investors can’t shift their assets within the fund to try to take advantage of specific market situations. This lack of control may not suit those investors who prefer a more active involvement.

Market capitalisation bias 

Index mutual funds that are weighted toward larger, more established companies can lead to overconcentration in particular sectors or industries, thus impacting returns and creating risk. Also, this may prevent investors from capitalising on the growth potential of emerging, smaller companies that might not be part of the market indices.

Tracking error

It refers to the difference between the performance of the index fund and that of the underlying benchmark index. Although index funds aim to minimise tracking error, various factors can cause deviation in performance, such as management fees, technical issues, the fund’s cash holdings or fund managers facing difficulties in buying/selling.

 Who should consider investing in index funds?

Every investor can consider index funds as a component of their asset allocation strategy. But they can be especially beneficial for first-time investors, as they provide an entry point into the equities market. While returns may be volatile over the short term, with the right index fund, these fluctuations can balance out over a longer timeline. As such, it is important to compare different index funds, their past performance, expense ratio, and, most importantly, tracking error so that the fund aligns with your goals, risk tolerance level, and capital needs.