Investors are constantly looking for passively traded funds due to concerns about the ability of fund managers to deliver high returns. That’s why the index fund has become a popular financial instrument over the years. These financial instruments can help diversify your portfolio across different sectors.
An index fund is perfect if you want to invest without the risk associated with actively managed funds. Furthermore, index funds can remove bias during investment decisions with a predefined investment amount. But while choosing index funds, you must carefully evaluate two factors to get optimal returns.
● Compare the Expense Ratios
Every mutual fund investment has an annual fee called the expense ratio to cover the different operating expenses. Your regular fund statement does not clearly mention the amount you are paying as the expense ratio. The expense ratio gets directly deduced from your assets in the fund. So, the expense ratio largely influences your returns from a fund.
But fund managers are not required to do much to look after index funds. The fund manager only needs to start the composition of the index.
Since index funds are passively managed, they have a lower expense ratio than funds managed actively. But you should still check the expense ratio of an index fund. If you find two funds following the same index, you should opt for the one with a lower expense ratio to get higher returns.
● Check the Tracking Error
An index fund works by replicating the performance of a particular index. If an index performs well in the market, the fund following it will deliver high yields. Similarly, your fund will suffer losses if the index performs poorly in the market.
The tracking error reveals whether a fund could imitate the movements of the index it is following. If your fund is unable to copy the movements of its index, a tracking error will occur.
For instance, an open-ended fund follows the movements of Sensex. Now if Sensex goes up 1% but your fund moves up only 60 basis points, a tracking error will occur.
You should always opt for a fund that has a minimal difference from the index it is following. Therefore, an index fund with a low tracking error is more favourable for investors.
Conclusion
Several investors are confused between choosing ETFs and index funds. Remember that you should pick the financial instrument that can copy the market movements of an index at the lowest possible cost.
As long as you pick the right index fund, you can get good returns. So, assess the expense ratio and tracking error of different index funds and add the best one to your portfolio.
FAQs:
- Is it good to add an index fund to my investment portfolio?
Index funds can deliver better returns than various other types of mutual funds in the long run. Moreover, index funds have low fees and tax advantages. Therefore, adding index funds to your portfolio is quite prudent.
- Is SIP suitable for investing in index funds?
SIP is perfect for investors who have a small amount of money to invest regularly. But if you have a high investment amount and risk tolerance, you should opt for lumpsum investments.
- Are index funds suitable for the long term?
Index funds are one of the safest long-term investment instruments. You can get huge returns from index funds in the long run with low risk.
- What is the ideal holding for an index fund?
The ideal period for holding index funds is seven years to minimize risks. Additionally, your returns are usually higher when you stay invested for a long time.
- Does it matter which index fund I pick?
You need to be extremely careful while selecting index funds because not all of them are low-cost. One fund might be better at tracking an index than another. Furthermore, you should be careful because index funds don’t make you immune to the risks in the market.
Disclaimer– Mutual Fund investments are subject to market risks; read all scheme-related documents carefully.
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