Index Funds: The best investment option for first-timers, says Porinju Veliyath

Index Funds Investment: If you're new to equity investing, index funds can be the ideal choice, with the potential to surpass other asset classes in the long run.

In a conversation about the future of investing, Porinju Veliyath, Founder, Equity Intelligence and renowned investor stressed that Index Funds are the best choice for beginners looking to invest in stock market.

With the Indian economy on the verge of major growth, he believes that investing in index funds will not only provide stable returns but will also outshine other asset classes in the long run.

"I think an index fund investing will really help. It's going to create superlative return than any other asset class index fund for that matter," Veliyath told Republic Money at the India Economic Summit held at Republic's National Headquarters.

His remarks come at a time when mutual fund investments are on the rise, with SIP contributions crossing Rs 25,000 crore per month, signaling a shift in India's investing sphere.

Index Funds offer a low-cost way to invest in the stock market with predictable returns, diversification, and minimal risk. They are particularly suited for long-term investors looking to mirror the overall market performance without getting involved in stock-picking.

What are index funds?

An Index Fund is a type of mutual fund that aims to replicate the performance of a market index, such as the NSE Nifty or BSE Sensex. These funds are passively managed, meaning that the fund manager invests in the same stocks as those in the underlying index and in the same proportions. Unlike actively managed funds, where a fund manager picks stocks based on predictions and strategies.

Index Funds simply track the performance of the index they follow. Their goal is not to outperform the market but to provide returns that are consistent with the market index they are replicating.

For instance, if an Index Fund tracks the NSE Nifty 50, it will invest in the 50 stocks that are part of the index in the same proportions. The fund’s performance, therefore, mirrors the movements of the Nifty 50, aiming to match its returns.

What defines your returns?

When you invest in an Index Fund, you are essentially buying a small share in all the companies that make up the index. The performance of the fund is tied to the performance of these companies. If the index goes up, so do your returns; if it drops, so do your returns.

For example, a fund that tracks the NSE Nifty will hold stocks like Reliance Industries, HDFC Bank and Infosys , proportionally aligned with their weight in the index. Broader indices, like the Nifty Total Market Index, may include a wider range of stocks, sometimes up to 750, encompassing companies of all sizes from various sectors.

Benefits of Index Funds

Index Funds offer several key advantages, including low costs due to their passive management style, which results in lower expense ratios compared to actively managed funds. They provide instant diversification by tracking a broad market index, like the Nifty 50, spreading investments across various sectors, and thereby reducing risk.

Since they aim to mirror the performance of the index, Index Funds offer predictable returns, making them suitable for long-term investors. Additionally, they tend to be less volatile than actively managed funds, as they don’t rely on stock picking, making them a straightforward and easy-to-understand investment option, especially for beginners.

Risks to consider

While Index Funds are generally low-risk compared to actively managed funds, they do come with certain risks as they track the market, if the market as a whole goes down, so will the index and your investment.

Tracking error is the difference between the performance of an index fund and the index it tracks. For example, if the Nifty 50 Index grows by 10% in a year, you would expect your index fund to grow by the same amount. However, if the fund only grows by 9.5% or 10.5%, the difference (0.5%) is the tracking error.

A low tracking error means the fund is closely following the index, while a high tracking error indicates a larger gap between the fund’s performance and the index’s performance. Ideally, you want a fund with a minimal tracking error for better alignment with the index.

Who should invest in Index Funds?

Index Funds are suitable for long-term investors who are looking for consistent returns over time. Investors who prefer low-cost options and are not looking to pay high fees for actively managed funds. Those who want diversification without having to pick individual stocks. Risk-averse investors who prefer the stability of market averages.

Things to keep in mind before Investing in Index Funds

When investing in Index Funds, focus on selecting funds with low tracking error and expense ratios to ensure they closely follow the index. Stay invested for the long term to ride out market fluctuations, as these funds perform best over time.

Additionally, include Index Funds as part of a diversified portfolio by balancing them with debt funds or gold. If you're concerned about market timing, consider using Systematic Investment Plans (SIPs) to invest regularly, spreading your investment over time and minimising short-term volatility.