How to select index funds

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With the stock market close to its record peak levels, it is natural for most of us to want to know what could be the best way to get exposure to the benchmark Nifty or Sensex indices without taking too much of an equity risk exposure.

However, it may not be possible to invest large amounts of money to actually buy a Nifty Index on the stock market directly. Index funds then come into the picture to give us the ability to invest in the same stocks as those in the Nifty or Sensex indices.

This is because an index fund buys and holds all the underlying stocks of a particular index, in the same proportion, thereby becoming a passive investment vehicle. As such, since there is no active fund management or additional research and analysis, these funds have low expense ratios.

But there are as many index funds as there are mutual fund companies and indices. How does one choose and buy the best index fund? Should one simply select the fund that offers lowest expense ratio? Below are some free tips for choosing the best index funds:

  1. Identify the type of investment needed for your portfolio.

Selecting an equity index fund, such as Nifty or Sensex is suitable if one seeks long term growth with a matching risk appetite. For investors seeking stability, an index fund investment in a Bond Index is more suitable.

  1. Tracking error of the index fund

This is an important indicator that measures how closely an index fund tracks its benchmark index, minimising any difference in returns from the mutual fund versus the equity or bond index itself. Analysing the fund performance history with that of the index performance itself provides this information.

  1. Index funds v/s Exchange traded funds (ETFs)

ETFs may offer lower operating expenses but the cost rises when they themselves buy and sell underlying securities. For long term, a buy-and-hold, no-change investment strategy makes ETFs a more preferable option but if you wish to make frequent withdrawals or regular contributions, an index fund may be more efficient.

  1. Expense ratios

Not all index funds may be cheap. It is important to look at the expense ratios of some funds which may charge unnecessarily higher administration/other expenses to the fund. These must be avoided.

  1. Examine the index the fund tracks

This is fundamental to the exercise of choosing your index fund. These funds may follow a market-cap weighted broad market index or equal-weighted market index.

Others may be tracking a particular sector weighted index. It is important to understand the index construction methodology so as to be able to match it correctly to your portfolio.

Thus, while their low cost attracts many investors into index fund investing, it pays also pays to follow these steps in order to successfully pick a winning fund suitable for your portfolio.

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