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If It’s Hard to Beat the Market, Isn’t it Ideal to Invest in Index Funds?

28 April 2022

The stock market is a fickle thing. One moment, you’re flying high, the next, you’re crashing down to the ground. This volatility can make it challenging to gain any real returns and a lot of investors balk at the idea of putting too much faith in something so unpredictable.

One of the most crucial decisions an investor can make is how to invest their money. In the past, investors have largely relied on active fund managers to beat the market, but those have been proven ineffective in recent years. Index funds have become more popular over the last couple of decades because of their ability to track market indexes.

Index funds are essentially baskets of securities that track an index, such as those mentioned above. Historically, they’ve been able to consistently outperform other types of investments. Plus, with very little management or maintenance required on the part of their investors, index funds are low-cost options for anyone looking to add diversity to their portfolio without having to manage multiple individual stocks. 

So what actually should be an ideal choice? Index funds or actively managed funds? Before that, note that passively managed funds may not always be Index funds but index funds, in general, are passively managed. Let us understand more deeply about these funds and some basic concepts around them to reach a conclusion. 

There are two primary types of mutual funds: actively managed funds, and index funds.

What is an Index Fund?

Index funds are designed to track a specific index of the stock market. These funds are not actively managed; instead, they are designed to track a specific index by holding all of the securities that make up that index.

Investors who wish to track these indexes can purchase an index fund from their mutual fund provider.

Actively Managed Funds

Actively managed funds are managed by professional investors who try to beat the market by purchasing stocks that they believe will outperform other stocks in the market. Since these funds are actively managed, they are more expensive than index funds because of the fees associated with hiring investment managers and analysts. However, these fees can be offset by higher returns if the fund performs

Actively managed funds have become the most popular form of investment in India, with approximately 80% of investors choosing them over the more traditional index fund.

Actively managed funds are appealing to investors because they offer a wide range of choices, and there is often a diverse selection of both domestic and international sectors available to choose from. There is also a greater potential for growth with actively managed funds than there is with index funds, as they are not subject to market fluctuations in the same way that index funds are.

By contrast, index funds offer less choice, as they are simply a collection of assets (typically shares) designed to match or track the performance of an underlying asset or benchmark (for example an index). They tend to be lower in cost than actively managed funds, but they also carry less risk and volatility than their actively managed counterparts.

Passively managed funds, such as index funds, are designed to track a particular market or index. These funds have lower expense ratios and aim to match the performance of their respective indexes.

Because index funds are passively managed, they do not rely on a fund manager to identify securities and make trades. Instead, a computer algorithm tracks the securities in a given index and makes trades that mirror the activity of those securities.

What Does it Mean by Passively Managed Funds?

This is different from an actively managed fund, which means that the manager of the fund has more control over what stocks and other securities go into it, and they can make changes as they see fit.

Passive funds tend to have lower fees than active funds—after all, it costs less for managers to buy and hold securities than it does for them to do extensive research and move money around. However, this doesn’t necessarily mean that passive funds will outperform active funds—it just means that their costs are lower.

Passive VS Active Management of Mutual funds

The question of whether to choose an active or passive approach when investing in mutual funds has been controversial for some time, and there are many factors to consider when making your decision.

Just like with any other investment, you want to make sure you’re choosing the best option for your needs. Here’s a closer look at the differences between active and passive management so you can make an informed choice.

Passive Management is a method of investing in securities such as stocks, bonds, or other financial instruments. The investor purchases securities that are expected to track a market-weighted index, so rather than trying to beat the market, it simply aims to match its performance. This method of investing is typically employed by investors who have a longer time horizon, and who are not worried about short-term fluctuations in the market.

Active Management is also a method of investing in securities such as stocks, bonds, or other financial instruments. However, this method employs fund managers who actively seek to outperform the overall market by selecting and timing investments more skillfully than those investors who are passively managed do. This method of investing has been shown to be less reliable and more expensive than passive management; however, it does allow for more customization within the portfolio.

Isn’t it Ideal to Invest in Index Funds?

An index fund is a type of mutual fund that aims to create a portfolio that tracks the performance of an index. The idea behind index funds is to minimize fees and maximize returns by tracking broad market movements.

Index funds in India are considered “passive” investments, as opposed to active funds where a manager actively buys and sells securities based on his or her judgment of the market. Since index funds do not require much management, they can typically be offered to investors with lower fees than active funds.

Investing in index funds is a popular way for investors to take advantage of the benefits of the stock market without having to actively manage their investments. But is this strategy really as good as it seems?

One downside to index funds is that they tend to underperform in periods when stock prices are rising. When used as a standalone investment strategy, they can result in lower returns over time.

To maximize returns on an index fund, you should use the following techniques:

1) Invest only in stocks that have been shown to outperform the market.

2) Be selective about which stocks you buy and avoid buying stocks with high volatility or risk.

3) Use stop-loss orders to protect against large losses when selling shares at a loss.

4) Rebalance your portfolio with new money as needed so that you always have cash available for emergencies.

Index Funds: The Advantages

Investing in index funds may be one way to go. If you’re interested in investing passively, you should consider investing in index funds. Here’s why:

  1. They’re cheap: Index funds generally have low expense ratios and no sales charge or transaction fees.
  2. They’re easy to buy: You can purchase index funds directly from the fund company or through a brokerage firm that offers access to the fund company’s products. The process is simple, and most brokerages don’t charge any transaction fees for buying index funds.
  3. They’re diversified: Most index funds are diversified across many different industries and geographic regions, which means your money will be spread out over multiple areas of the economy and won’t be too heavily weighted in any one area. This helps mitigate risk.

Index Funds: The Disadvantages 

Index funds are indeed a popular investment choice because of the mantra “it’s hard to beat the market.” This is true. The market is made up of all the stocks and it is difficult for anyone investor to beat it. However, there are a couple of reasons why you should rethink investing in index funds:

  1. They are not as diversified as you think. There are thousands of companies out there that could potentially provide better returns than those included in the popular ones.
  2. They do not necessarily follow what an investor wants for their portfolio. In fact, most index funds only offer one type of fund, which means you will get whatever they decide to include in that fund regardless of your own goals as an investor. You may be better off with an actively managed fund that can select stocks according to your specific needs and preferences.
  3. You can lose money if you don’t know how to invest correctly.

Bottom Line

Even if some types of investment look more tempting than others, the most important part of determining the best investment for yourself is knowing your goals. Once you understand what you want to get out of an investment, you can use a combination of available tools and research to help you find an investment that will help you reach those goals. Becoming an ideal choice because of its low expense ratio, index funds might not fit your financial goals.  Some investors make money through actively managed funds while for some passive investment might seem like a suitable option. 

The ideal investment option for you depends on your interests and your risk tolerance, but generally speaking, the best way to invest is to diversify. You can do this by investing in a variety of stocks, bonds, and other types of investments. 

Disclaimer

The stocks mentioned in this article are not recommendations. Please conduct your own research and due diligence before investing. Investment in securities market are subject to market risks, read all the related documents carefully before investing. Please read the Risk Disclosure documents carefully before investing in Equity Shares, Derivatives, Mutual fund, and/or other instruments traded on the Stock Exchanges. As investments are subject to market risks and price fluctuation risk, there is no assurance or guarantee that the investment objectives shall be achieved. NBT do not guarantee any assured returns on any investments. Past performance of securities/instruments is not indicative of their future performance.
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