Are Index Funds a Safe Investment for Investors?

Index funds have been gaining prominence in recent times. Read this article to find out whether such funds are a safe investment option for investors.

Many financial advisors are asking investors to include or raise the allocation to index funds in their investment portfolio. They say that since these funds follow a passive investment strategy to imitate certain indices, they are a cost-effective option. Additionally, the performance of index funds in recent times has supported their case. In this article, we will look into whether or not index funds are a safe investment option for investors, and who should opt for them. But first, let us understand what index funds mean and how they function.

Index funds are a type of mutual fund whose portfolio matches or tracks the components of a financial market index. Unlike actively-managed funds, index funds passively track a particular index’s performance. All the stocks are purchased in the same proportion as in a particular index. The performance (of index funds) is directly proportional to that of the benchmarks. It is important to note that index funds follow their benchmark index, irrespective of the state of the markets.

This investment route is best-suited for individuals who have a low-risk appetite and expect predictable returns. Given that these funds don’t require extensive tracking, they are apt for investors who don’t want to take the risk of how a fund manager is performing. It can also be considered by investors seeking to park their money in the broader market and prefer more diversification and lower costs.

Index funds usually suit investors who want to invest for the long term. The fund sees many fluctuations in the short-run, which can average out in the long-term to fetch returns in the 10%-12% range. People opting for index funds must be patient enough to remain invested for at least seven years or so. It is only then the fund will be able to perform at its full potential.

According to a report by The Economic Times, the AUM of index funds has increased

from Rs. 5,971.84 crore in August to Rs. 7,622.61 crore in October. In recent times, when the market has seen a correction, a number of index funds have performed better than actively-managed schemes. Now, just like any mutual fund investments, there is a certain degree of risk with index funds as well. It is subject to the same risks like the securities in the index it tracks. Some of the other risks involved with index fund investments include - lack of flexibility, tracking error and underperformance.

It must be noted that index funds track broad-based indices - thus bringing down the impact of the decline in value of any one stock or sector. Many are increasingly preferring index funds over ETFs so as to avoid the hassles of maintaining a demat account and poor liquidity.

Source: CRISIL

Source: CRISIL

Before selecting an index fund, investors are advised to analyse the fund from different angles. There are a number of qualitative and quantitative parameters to find out which would be the best index fund, as per the investors’ requirement. Additionally, individuals are advised to keep in mind their financial goals, investment horizon and risk appetite.