Finance

Should you switch to index mutual funds

Several mutual funds charge fees of up to 2%, no matter how good or bad the fund is doing. You could be losing your money and they would still charge you operational fees, also known as an expense ratio. On the other hand, index funds theoretically don’t charge very much in terms of fees. Let’s understand between the choices of these two mutual funds.

As an investor, you are always offered with a choice of being apassive investor or an active investor. An active investor is the one who is willing to undergo stock selection risk to higher returns. A passive investor is the one who follows passive style of management, i.e. the fund manager does not contiously track the market to invest in the best set of mutual funds, rather they track an underlying index. One of the most common categories of mutual funds that follow the passive style of management is index mutual funds.

What is index fund?

Index funds imitate a stock market index such as BSE Sensex, NSE Nifty, etc. These funds are passively managed mutual funds meaning that the fund manager invests in securities having similar proportions and allocations as in the underlying index it follows. As index funds rely upon and follow the underlying benchmark, these funds do not need a dedicated team of research analysts to identify new opportunities and pick the best mutual funds. Thus, index funds returns are aligned to their underlying market index. The latest re-categorisation of mutual fund schemes by Securities of Exchange Board of India (SEBI) has also contributed to the increasing popularity of index funds in India.

So, does that mean that an investor should move to index funds entirely and ditch their actively managed funds?

It’s way too early to think that as an active fund manager will strive to generate better returns than passive index funds. An active fund manager will always emphasis on producing the alpha, especially, given the fact that our stock market is still developing. An investor often makes a mistake of comparingindex funds India to a developed market like the US, which is not the correct approach as it’s not an apple to apple comparison.

Then there are other significant reasons like flexibility, that an active fund manager has in picking up the qualitative stocks to surpass the passive index funds. Hence, as long as the fund manager is doing a good job in generating the alpha, the fund will have the upper hand at beating the index fundsthat only copy the benchmark indices, thus making you lose the possibility of making significant returns.

Ideally, one should create a good mix of index funds and mutual funds that match their risk profile.You can also consider taking the services of a mutual fund expert who will also guide you on how to invest in index funds. Happy investing!

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