Index funds are believed to be ideal for those who are risk-averse and expect predictable returns. Since index funds are not actively managed by fund managers, they incur low expenses and help an investor balance his risks across his investment portfolio. They are based on an underlying index like Nifty or Sensex, and these funds simply mirror the performance of that index. Index funds are free from fund managers' biases and are the most advocated way of investing by experts for retail investors. These funds do not aim to outperform the market. Instead, they try to maintain uniformity.
For example, an index fund tracking Nifty will have all the 50 stocks in its portfolio in the same proportion. Typically, index funds give returns equal to the benchmark. However, there could be a tracking error, meaning there is a possibility of a small difference between fund performance and the index.
Good returns: Since Sensex and Nifty have performed well over time, index funds promise good returns over a long time. The big problem with diversified equity funds is human discretion in choosing one over the other. The discretion has a very strong element of conditioning, biases, and past experiences of the fund manager. But index funds overcome these biases because of their passive nature.
Low costs: The costs in an index fund are lower. Investing in index funds is a good option if you want high returns amid a rallying market. However, in India, index funds have not taken off in a big way because most fund managers (about 70 per cent) have been able to beat the index. In the US, it is about 15 per cent. Once the index methodology becomes tighter, the returns between active funds and passive funds is likely to reduce.
Buy, sell any time: Investors can buy or sell index funds any time they wish at the price prevailing at that time.
Lack of flexibility: Index funds lack flexibility. In active funds, a fund manager can decide or change the asset allocation if he/she finds the market to be volatile, but this can't be done in index funds. An index fund requires the investor to be fully invested in the index at all times.
Vulnerable to tracking error: Despite being free from biases of the fund manager, index funds are still vulnerable to tracking error. Experts advise that investors should go for index funds that have low tracking errors.
Potential fully not explored: Index funds have not been great performers in the past in India, but they have the potential to become a lot more attractive in the coming years. It is important to have a mix of actively and passively managed funds to reduce risks. Though index funds offer good returns during a market rally, experts say it is better to switch to active funds during a slump.