The Smart Investor's Guide to Index Funds

Five reasons why new investors should pick passive funds New investors are worried about the time and energy it takes to keep track of the market and its inherent risks. Passive investing can come in handy for individuals who are patient and are looking for a safe mode to park their funds. What is passive investing? A passive fund mimics the growth of an index, say Sensex or Nifty, and replicates its returns for investors. For example, if one invests in a five-year-old Nifty50 fund, the returns of the fund and that of index will be the same, and indices seldom fail. We have two types of passive funds - ETFs (exchange-traded funds) and index funds. Here are five reasons why new investors should consider them: 1. They're simple and easy to understand Investors must invest in products they can understand, and passive funds are as simple as they can get. They invest in an index and the fund will choose stocks that will provide the same collective returns as the index. It could be a Midcap150, Nifty50 or Nifty500 index, so on and so forth. 2. It will not 'cost' you Yet another brilliant advantage of a passive fund is that it is chosen by an algorithm. As the scheme is not actively managed but is passively managed, the costs are low. On the contrary, active investing would require continuous research and constant churning of the portfolio, and there are fees associated with it - at around 1 per cent. If an investor goes for a 15-year-time frame, the 1 per cent fees gets heavy. It would compound over time and could be as high as half the portfolio. For long-term investments, the lower the cost, the better, as it would determine the quality of returns. With passive funds, an AMC only charges the expense ratio. 3. You can manage risks better After every mutual fund ad, the disclaimer says, "Mutual funds are subjected to market risks." In truth, a typical fund is subjected to both fund manager risk and market risk. In a passive fund, it is pure market risk, as a fund manager's stressed decisions will never affect them. The fund will keep picking stocks that are the best performers in the underlying index. 4. The bad apples can be weeded out This is a concern that most people have about passive funds, but let me put such doubts to rest. The indices weed out stocks that underperform and slip down. When this happens, the fund too automatically pulls them down, so the average returns over time stay the same. It's like this: one stock crashing won't affect the index for too long. Passive funds are similar. Also, the effect of one stock over 200 others gets cancelled out in most cases. Passive funds are capable of absorbing these shocks. 5. Best among equals Most active investors long for a diverse po