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How to choose index funds

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THERE are several conditions under which investors can look to invest in index funds. These are funds that track a particular index, so the performance of these funds is similar to the performance of the index.

Index investing represents an alternate way of going about the investment process. When it comes to the question of conditions when it makes sense to select such funds over the actively managed fund there are a few situations when it would be appropriate.

Passive funds: Index funds are passively managed funds and due to their very basic nature they will not be expected to outperform the market or even its benchmark index. The aim behind these funds is that they will track the returns of the index and hence they will perform similar to what an index delivers. This is achieved by having the portfolio of the fund constructed in the exact manner in which the index is present. This will also require that there is some rebalancing that is done after a period of time so that the composition remains in the same proportion. While there are advantages and disadvantages of the instrument there can be specific conditions when such funds seem to be a better choice.

Markets and investor belief: If one of the central beliefs that you have as an investor is that it is very difficult for a fund manager to beat the market over the long term then you need to look towards having index funds as a part of your holdings. Since the belief states that the market cannot be beaten, the next

best thing that the investor can do is to ensure that the performance of their investment is at least in tune with the markets so the index funds come into the picture. When this is the case then there would be a position where the main objective of ensuring that you earn at least as much as the market is achieved and this is done using the index fund route.

Broad based indices: There is a slightly easier way of outperforming some of the well known indices by choosing shares or companies that are outside of the index or of a different market capitalisation and this might continue for some point of time.

However when it comes to the question of a larger proportion of the market then consistently beating the broad based indices over a period of time is not an easy task at all. In such a position it is better if the investor takes a look at the index funds for such indices as this will provide them with the specific type of exposure and also keep their returns in tune with the changes taking place.

What is also essential in such a situation that the tracking error is considered very carefully because if this is large then the entire decision of selecting an index fund will no longer be relevant.
 

Low cost: One of the aims of the investor is to have a lower expense ratio while investing in funds as this is ultimately being paid by them from their investments. When this is the aim and there are a lot of actively managed funds where this ratio is high then there should be a look at the index funds route because the cost here is far lower than what will be seen elsewhere. This savings ultimately results in a position where the outflow on the expense front for the individual is less and this will lead to a position where they will be able to earn higher net returns at the end of the day. For all those looking to keep their investment costs low this is a good way to go about the process.  

 

 

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