10 reasons to invest in Index funds
When we talk about equity markets, there are various avenues of investments from shares, different kinds of mutual funds to ELSS. Different people have different approaches to the equity market. That also depends upon the risk appetite, Patience, and discipline level of investors. There are traders who trade day in and day out In equities, short term investors who invest for 1-3 yrs, medium-term investors with investment horizon from 4-9 yrs, and long term investors who invest for 10 yrs plus.
This blog will focus on discussing a range of stable investment instruments in equity which can prove to be a great compounding tool and prospectively multiply the wealth of the investors over a period of time. This instrument is called the Nifty based Index Fund, popularly also known as ‘nifty bees’. An index fund is a combination of various shares in nifty in the ratio of its composition. A classic index fund represents the entire stock market basket and not just a few scattered eggs. Since it is passively managed it has a very low or negligible expense ratio compared to actively managed mutual funds. The ideal approach for investing in Index based fund is simply to buy and hold forever, but most people are not even aware of it as it is the least marketed product in the equity market. Let’s look at the top 10 reasons to invest in index Funds.
1. Cost-efficient- Equity Linked mutual funds are actively managed and have many in-built costs like brokerage, Fund management fees, portfolio transaction cost, fund operating expenses, advertisement and distribution cost, etc. As a result, actively managed mutual funds incurs an expense of 1-2% per year of its total assets which is also called an expense ratio. On the other hand Index funds are passively managed so their expense ratio is very low or negligible which creates a big difference in wealth creation in the long run.
Return of nifty since inception
2. Reduces Risk- Biggest investment guru warren buffet has famously said that there are 2 golden rules of investment "Rule No.1 Never lose money. Rule No.2: Never forget rule no.1". Investors should always try to minimize the risk when they make their investment decisions. Index funds only carry a stock market risk which is an inherent risk of investing in equity. All other risks like human bias, Individual stock picking risk & sector-specific risk are not there in an Index fund. the above historical chart of nifty since its inception shows that it has only given negative returns for 7 years and a positive return for 17 years.
3. Healthy Returns- Nifty based index fund has the potential to generate a return of about 12% per annum for long term investors who are looking to invest with the time horizon of 10 years +. Nifty has itself given a staggeringly high return of over 11.1% per annum since its inception. I will further put my point by presenting a fact that why this performance will be sustained in the future as well. Bank takes money from lenders at 6-7% in the form of FDs and then lend money at an interest rate of 9-11% to big corporations for their business requirements, know if corporates are getting their funding at 9-11% they have to earn at least 2-3% higher than the cost of funding to become profitable i.e. they have to earn 12% or more.
4. Eliminates human error- Performance of a mutual fund largely depends on skill sets of the mutual fund managers, who keep chasing alpha all the time to beat index which becomes difficult in the long run. The performance of mutual funds also gets adversely affected if the fund manager decides to move out from the fund and the new manager does not match the desired standard, which leaves a dent on the wealth of long term investors. Whereas Index fund eliminates the risk of individual stock & sector selection, manager selection, human bias and only stock market risk remain.
Composition of Nifty- Provides adequate diversification
5. Advantage of Diversification- Index fund provides benefits of diversification as money invested in Index funds is invested in various companies across the sector in the proportion of its weight in nifty.
5. Benefits of Compounding- Being a stable investment option, investors can comfortably park their money in an index fund for the long term and multiply their wealth by earning benefits of this wonderful compounding tool.
7. Good for passive investors- Famously endorsed by Warren Buffett “ By periodically investing in an index fund and know-nothing investor can actually outperform most investment professionals”. Index funds allow retail investors who do not have any knowledge about the share market to invest in equities and earn their fair share of the return.
8. Replication- Good number of diversified mutual funds is the only reflection on Index fund as they park a major portion of their investment in index heavyweights. The investor does end up paying a higher expense ratio for limited benefits.
9. Hedge against inflation- In our country inflation rate is about 6%, investment in Fixed deposits(FD) will not help to beat inflation in the long run as its net return falls well short of inflation. On the other hand, investment in Index fund helps retail investors not only beat inflation but also create handsome wealth over time.
10. Return of mutual fund falls with its size- Fat wallet is negatively proportional to the high return. When the mutual fund starts doing well, money chases it and the fund starts to get bigger and bigger over a period of time, as higher number of investors finding it to be a lucrative option to invest. Mutual fund Managers then face a challenge to either buy their favorite stocks at high prices or invest in less favorite stock because they cannot hold cash more than 5%-7% of its fund corpus; as a result, the performance of mutual funds suffers negatively in the long run though it is currently beating the market. Whereas when the market falls, investors start redeeming the money from mutual funds hence fund managers are forced to sell at lower prices which causes a big dent in the return of mutual funds.
To conclude, an Index fund is a good investment option for conservative retail investors who are looking to earn their fair share of return, provided one keeps patience and disciplined approach towards investment. It is advised that investors should start accumulating Index funds through monthly SIP(systematic investment plan). It allows them to take advantage of buying at different price points. Ideally, Investors should invest in equities for a long term horizon of 10+ years to get the maximum benefit of compounding. It is a great time to start investing in an Index fund as the index has corrected over 25% from its peak and investors now have the opportunity to start accumulating it at a lower level.
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