Investing is important to achieve financial security and freedom. Many investors want to diversify their portfolio, but with work and other responsibilities, they don’t have the time to monitor the stock market. Others may have less expertise to pick individual stocks, and some may not have the risk appetite to manage investments actively. This is where passive investing plays an important role.
Index funds are mutual funds that follow a passive investment approach and require little to no intervention from investors. These funds offer a simple yet effective way to invest without having to worry about individual stock selection or thorough market research. However, to make the most out of your investment, it’s important to consider several key metrics in your decision-making process.
From tracking error and expense ratios to historical performance and liquidity, let’s take a closer look at what to consider when investing in index funds.
- Expense ratios
Expense ratios are the annual fees charged by mutual funds to manage your investment. Although index funds usually have lower expense ratios compared to actively managed funds, they can still vary depending on the fund.
A lower expense ratio helps you keep more of your returns and make a big difference in long-term gains. Therefore, compare expenses across different fund options so that you don’t pay more than necessary.
- Diversification (portfolio holdings)
Index mutual funds are known for their diversified portfolios but it is important to check the level of diversification the fund offers. Look for a fund that has holdings across different sectors and market capitalizations. This will help to ensure that you are exposed to multiple companies and industries, minimising the possibility of significant losses due to fluctuations in any one sector.
Higher diversification will provide more stable returns and better risk management.
- Liquidity
Liquidity refers to how easy it is to buy and sell the fund. Choose an index fund with high trading volume that can be easily traded so that you can sell your investment quickly without experiencing significant price fluctuations.
An index fund with high liquidity provides flexibility and allows you to react to market changes quickly. Without liquidity, you may struggle to sell your investments when needed, leading to missed opportunities and even losses.
- Past performance
While past performance cannot guarantee future success, it can provide insights into how well the index fund has performed over the years. Analyse the fund’s performance over at least 4 to 5 years. This helps you get a clearer picture of its consistency, stability, tracking error, and response to different market trends.
- Tracking error
Tracking error refers to the difference between the returns of the fund and the returns of the benchmark index it aims to follow. Ideally, the tracking error should be as low as possible to ensure that the fund is accurately following the index.
A fund with high tracking error means its returns deviate significantly from the returns of the benchmark index it follows. It can be due to higher mutual fund expenses, issues with the fund’s management, or difficulties in buying and selling. This deviation can result in performance discrepancies and can negatively impact your mutual fund returns.
- Fund provider
It is important to invest in mutual funds offered by reputable, established fund providers who have a proven track record of delivering solid returns with minimum costs. Moreover, consider the company’s investment philosophy, management team experience and risk management strategies in different market cycles.
Final words
Index funds offer a cost-effective way to get exposure to different asset classes and securities that are important for a diversified mutual fund portfolio. But the key is to know the things to look for and implement the right strategies.
Simply investing in index mutual funds is not enough. It is important to stay disciplined and invested for the long term. A long-term approach allows short-term fluctuations to even out over time and optimise returns through power of compounding. You can also set up a systematic investment plan (SIP) to bring discipline and consistency to your investments and leverage market fluctuations through rupee cost averaging.
