Over the past decade or so, mutual funds have become a popular investment option for both new and old investors. However, the sheer plethora of choices can be bewildering to new investors who do not have the experience or the know-how to understand which fund would be best suited for them. Financial experts today advise new investors to try index funds if they are new to the world of mutual fund investment. Here is a look at why investing in index funds is a great idea if you are new to investments.
What are index funds?
An index fund is an open-ended mutual fund that invests most of its corpus in the underlying securities that make up a benchmark like the SENSEX 100 or the NIFTY 50. They invest at least 95% of their corpus in equity and equity-related investments of the companies listed under a particular index. Actively-managed funds like equity funds attempt to outperform the benchmark. However, with index funds, the fund attempts to track and duplicate the returns of a specific market index.
Index funds are passively managed. Unlike equity mutual funds, for example, they do not have fund managers using their experience, skills, and knowledge to decide which funds to invest in, when and what to sell, and so on.
Why are index funds great for new investors?
Investing in index funds has many advantages for all investors, but perhaps especially so for new investors.*
- It can act as a starting point for new investors who are looking to get exposure to equities. Equities can be a great investment if you know how to choose your equity mutual funds. However, they are also subject to more volatility than a new investor may be prepared for. Instead of spending time and resources trying to track actively-managed mutual fund schemes, newbie investors can choose an index fund investment. It will mirror the returns of an index with a minor tracking error.
- Diversification is the key to a well-rounded portfolio that minimises exposure to unnecessary risk. However, diversification can be tricky to get right when you are a new investor. When you invest in index funds, your portfolio is automatically diversified. An index will hold multiple and varied types of stocks. By investing in an index fund, your portfolio is instantly diversified among so many different stocks. So, your portfolio is not focused on the fortunes of any particular stock listed on that index.
- Index funds help minimise and omit human bias and errors generated by human discretion and emotions. An actively-managed fund will be run according to the biases, conditioning, and experiences of its fund manager. Whereas an index fund will simply try to track the performance of an index freeing it from errors and bias arising from human discretion.
- Index funds have great potential to offer good returns when investors adopt a long-term investment horizon. We can see this when we look at India’s two indices. In 1979, the Sensex had a base value of 1979, since then it has given investors staggering 35-fold returns. Nifty’s base year was 1995, in 23 years it gave investors 11-fold returns. As of 26 June 2022, Sensex grew over 70% in the past five years alone. In the same time frame, the Nifty grew by 65%. So, if investors had invested in an index fund that followed these indices, they would have made excellent returns over time.
- Index funds are cheaper than many other mutual fund types. Actively-managed mutual funds have higher expense ratios of 1 to2%. A bulk of this fee goes toward paying the fund portfolio manager who makes decisions about buying and selling to outperform the benchmark. Passively-managed funds like index funds require little work on the part of the fund manager as they just track the index and buy and hold the stocks of an index. So, these funds’ expense ratios are very low, saving the investor more money. Hence, index funds may be ideal for new investors who have a long-term financial goal in mind.
- The tax benefits associated with index funds are better than those of other mutual funds. Index funds are passively managed; they do not buy and sell securities as often as actively-managed mutual funds. Actively-managed mutual funds tend to have high turnover ratios that amass capital gains regularly, thus, resulting in the fund’s investors owing more capital gains taxes. Index funds have low turnover ratios since stocks are not bought and sold as regularly. So, the capital gains are lesser, resulting in lower taxes.
Investors new to the world of investing and mutual funds should opt for index funds. They should look for index funds with low tracking errors. Moreover, they should choose a systematic investment plan as a way to invest in index funds as that has the capacity to give them the greatest returns.