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How To Choose The Right Index Funds For Beginners

Passive investing is one of the best ways to earn money in the long term. Here’s an in-depth guide to choosing the right index funds.

If you’ve researched personal finance at any point in your life, you’d have come across the phrase “Mutual funds sahi hai.” which roughly translates to “Mutual funds are the perfect fit.” This common advice is given to all beginners in their investment journey to financial independence. A simple solution to such scenarios is to consider index funds. These funds, which track an index and do not involve any active stock-picking approach, have been soaring in popularity in India.

But, if you follow up on that advice, and plan to invest in a mutual fund, you’ll find that there are quite a few mutual funds to invest in. While they’re categorised based on different factors, they could probably overwhelm you. Especially if you’re only just starting out investing. It’s why we’re here to help.

Let’s begin by highlighting the common mistakes beginners are prone to make. These include:

  1. Choosing the best performing fund to date. Using this strategy may not always pan out well, as historical success does not equate to future success.
  2. Juggling and churn between various mutual funds, leading to overall lower returns.
  3. Falling prey to fund manager bias, or not understanding the goals and philosophies of the fund manager.
  4. Getting confused with the wide variety of funds available

Executed correctly, choosing the right index funds over active funds may prove extremely advantageous for both amateur and seasoned investors. Such an approach:

  • Narrows down the number of prominent funds available for you to invest,
  • Eliminates fund manager bias, and
  • Is relatively inexpensive to maintain, both in terms of cost and time

These characteristics make index funds one of the best options available for investors. And while active funds managed by skilled experts do deliver impressive returns, contrary to popular belief, they do not always outperform their index.

Several factors go into determining which index fund you choose to invest in. Here are a few:

#1 Understanding Your Risk Profile As An Investor

One of the major factors that help determine which index fund you may choose to invest in is your risk profile. Assessing how much risk you’d be willing to take will help ensure that you maintain your target asset allocation, and ensure that you don’t position yourself super aggressively in a bull market, or extremely conservatively in a bear market. Both of which are a definite way to lose more money than you may gain.

Glide provides a free risk assessment tool that helps you understand your risk profile, and ultimately beneficial in choosing the right index funds for you.

It is important to understand that index funds are not in any way less fundamentally risky than an active fund, except for the risk of fund manager bias. But they do offer significant market diversification while carrying some market risks. It is essential that you understand and are comfortable with these market risks before starting your passive investing journey.

#2 Market Capitalisation: What does it mean anyway?

If you’ve been researching mutual funds, you may be familiar with the terms large-cap funds, mid-cap funds and small-cap funds. In the context of an index fund - when a fund invests a large portion of their funds in companies of large sizes, or those with large market capitalisations, it’s categorised as a large-cap fund.

Large market capitalisation is typically an indicator of a proven track record and good long term performance. Thus, funds which invest in these companies, i.e. large-cap funds tend to be less risky than funds which invest in companies with medium market capitalisation, or small market capitalisation (mid-cap funds, or small-cap funds).

#3 Should You Consider Sector Funds?

Sector funds are those funds whose indices track companies belonging to specific sectors, like real estate, medicine, FMCG, etc. Success from investing in sector-specific funds is dependent on timing the markets, which can be a risky move.

Sector-specific funds can be volatile and risk-prone, as they are likely to react collectively to macroeconomic events. This means that the value of sector-specific funds can be potentially impacted to a much larger degree than broader index funds. Conservative investors looking to start with passive investing may want to avoid sector funds.

#4 How about ETFs?

Exchange Traded Funds, or ETFs, are not index funds. However, they’re a popular passive investing option eyed by many investors. While index funds track the performance of a theoretical section of the market, ETFs are a basket of securities traded actively in the various stock markets.

Both are conservative long-term strategies to earn money in the long run. Passive retail investors (individual investors who prefer investing in passive funds) tend to invest in index funds rather than on ETFs.

#5 How Should I Choose The Right Index Fund?

An index fund’s performance can be analysed using the following metrics:

  • Tracking Error - The deviation of performance of the index fund from its target index. The lower the tracking error, the better.
  • Expense Ratio - The charges levied by the funds to maintain your investments. Ideally, it should be less than 1%.
  • Track Record - Historical performance of the index funds.

Following these three metrics would be an accurate indicator of how the funds tend to perform in the long run.

Choosing The Right Index Funds: To Conclude

Choosing the right index funds by keeping in mind your risk profile and asset allocation strategies is one of the best ways to generate returns in the long run. Index Funds are also subject to market risks and it is vital for you, as an investor, to be aware of and comfortable with all these risks before beginning to invest.

Of course, Glide Invest will be more than happy to help you on your financial journey, all through the way. Feel free to reach out to through our socials. Happy investing!

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