Index-based investing or passive investing is becoming extremely popular among investors these days. But what are index funds? An index fund refers to any investment following the market index. Since actively managed funds often struggle to deliver great returns, passively managed index funds are becoming a lucrative option, particularly in the large-cap space.
While you can also invest in an ETF to track an index, index funds offer a straightforward path. You can invest in an index fund without any Demat account, like investing in other mutual funds. Let’s acquaint you with the tips to find the best index fund and begin investing.
Look for the Lowest Expense Ratios
Several ETFs and index funds usually charge an annual fee called the expense ratio to bear all the operating expenses. The fund manager doesn’t have a significant role in managing index funds. The fund manager will have to simply initiate the composition of the index. Therefore, passively managed funds usually have a lower expense ratio than actively managed funds.
The fact that you are paying the expense ratio isn’t transparent because your regular fund statements won’t reveal how much you are paying as the expense ratio. The expense ratio gets automatically deducted from your returns as a certain percentage of your total assets in the fund. Therefore, the expense ratio has a direct bearing on your returns from a fund.
Suppose you find two index funds following the same index. But the one with a lower expense ratio will offer you better returns. Therefore, you should always be looking for index funds with the lowest expense ratio.
Look for Funds with a Low Tracking Error
A tracking error occurs when a fund fails to replicate the index movements. Suppose an open-end fund replicates Nifty. If the fund goes up by 80 basis points while Nifty rises by 1%, it will lead to a tracking error.
The tracking error is a measure of whether a fund can replicate the movements of an index accurately. The purpose of an index fund is to copy the performance of the index it is tracking. Therefore, a low tracking error or minimal difference between the two will work in your favour.
Don’t Be Concerned with the Difference Between ETFs and Index Funds
The difference between ETFs and index funds might be an area of concern for you while looking for passively managed funds. You might be wondering whether the difference actually matters while looking for index funds. The major difference between an ETF and an index fund is the frequency of the changing share price of the fund.
You can order an index fund at any point. However, the price during purchase or sale will depend on the value of the underlying securities at the close of the trading day. When you order an index fund after the market has closed, your trade will be processed according to the closing price of the next day.
The price of ETFs keeps changing throughout the day, just like stocks. Nowadays, you can easily go for buying or selling ETFs without any commission fee. As long as you are not paying any commission fee and the purchase price is low, you shouldn’t worry about the type of passively managed fund you are purchasing.
But while choosing between ETFs and mutual funds, you should go for the one that lets you recreate an index at the lowest possible cost.
If you are a beginner in the investing world and want to keep things simple, create an all-index portfolio with the help of only one fund. But if you want to control your asset allocation mix better, you can start looking for two or three funds.