Investors' Hangout: How to use index funds?

The rising popularity of index funds stems from their simplicity and easy understanding. Unlike the broader mutual fund market, which can be complex due to a wide variety of funds, index funds are relatively straightforward. Additionally, they offer the benefits of low-cost asset management. In India, the increased interest in index funds is partially due to mutual fund companies offering a diverse range of these funds.

Moreover, the significant inflow of money into index funds has been influenced by the government's mandate for the Employee Provident Fund (EPF) to invest in equities, often through index funds.

Despite being considered a lower-risk investment, it's crucial to remember that index funds, like any investment, are subject to market fluctuations. Therefore, maintaining a long-term perspective and investing regularly through systematic investment plans (SIPs) is vital. Avoid panicking during market downturns.

How can one use index funds to build a robust portfolio?

To construct a strong portfolio using index funds, start by keeping it simple. For example, consider investing in aggressive hybrid funds, allocating around 25 per cent to debt funds and 75 per cent to equity index funds (Nifty or Sensex-based funds). This approach is low-cost and easy to manage. For a more sophisticated portfolio, diversify your investments: allocate 50-70 per cent to large-cap funds, 20-40 per cent to mid-cap funds, and 10-30 per cent to small-cap funds. Remember that index constituents change over time, so your portfolio will naturally evolve.

For those seeking even more advanced strategies, explore options like the S&P 500, NASDAQ 100, and Hang Seng Index funds. These can provide exposure to different sectors and market segments, offering a well-diversified portfolio. If you prefer a simple, low-maintenance approach, consider a total market exposure index fund, which provides a balanced exposure across various sectors.

With so many index fund options, how does one choose the best?

When choosing an index fund, the differences between options like the Sensex and Nifty are minimal, especially over long periods. Focus on two key factors: the expense ratio and tracking error. A lower expense ratio generally leads to better returns, and a fund with a low tracking error closely replicates its index.

A viewer's question

Vinod asks: "Is it okay to invest in a small-cap fund for the long term, say 15 years?"

Investing in small-cap funds for the long term, say 15 years, can be beneficial. However, they're not suitable for new investors due to their high volatility. Despite the high returns seen in small-cap funds over the last decade, they have experienced significant drops, like in 2008. It's important for investors to be prepared for both ups and downs in the market.

Click here to register for the next episode of Investors' Hangout.