Index funds are an important component of any properly diversified investment portfolio. They offer a passive approach to investing, allowing investors to avoid the effort and complexity associated with analysing individual stocks and timing market movements. Index funds primarily track the performance of the underlying benchmark index without much active monitoring needed from fund managers making buy and sell decisions.
Despite these advantages, there are several myths about passive investing – with many investors associating index funds with low returns, high costs, and lack of diversification. Since these myths can lead investors to overlook this important strategy in their portfolio planning, here are four such misconceptions surrounding index funds busted and explained in detail.
Myth 1: A demat account is necessary to invest in index funds
This misconception arises since the broader market indices are typically composed of securities exchanged on stock exchanges and traded through demat accounts by investors. However, it is possible to maintain investments in index funds through investor folios with mutual funds without needing to have a demat account.
To trade in Exchange-Traded Funds (ETFs), it is important to hold demat and trading accounts. But you don’t need a demat account to invest in index mutual funds.
Myth 2: Index funds or ETFs are less risky than actively managed funds
While index funds may offer a more consistent risk profile due to mirroring the benchmarks and indices they track, this consistency should not lead investors to believe that they are inherently less risky than those of actively managed funds.
For example, suppose you are investing in equity index funds or ETFs. In that case, you are exposed to the same level of risk as with active equity funds. Both investments carry market risk depending on the nature of their underlying assets/holdings.The key difference is that index funds tend to closely mirror the performance of the index being tracked.Note that market fluctuations can impact all forms of equity investments, regardless of whether they are actively managed or indexed.
Myth 3: Always go with index funds with the lowest costs
While it’s true that having a low expense ratio is important, there are other factors that contribute to how closely an index fund tracks its benchmark. These include turnover, size, and type of securities within the fund and other details like levels of diversification and performance optimisation techniques used.
In some cases, a fund with a higher expense ratio may track its benchmark more accurately than one with a lower expense ratio. So, simply consider factors like whether the portfolio aligns with your goals and be sure to select an appropriate index fund or ETF type for your objectives.
Myth 4: Returns on passive funds will be aligned with the market
Passively managed funds track their respective indices, but it is not necessary that the returns will be completely aligned with the market. There exist cases when a fund can show a tracking error, causing its performance to deviate from the index. This deviation happens due to factors like cash positions in funds and fund managers taking excessive risks that reduce the impact of volatile markets or lead to the outperformance of the index.
However, if your index fund is consistently delivering higher returns than its index – this could be an indication of risky management styles or a manager struggling to mimic market performance. Ideally, you should expect nominal tracking differences and returns similar to the index.
So, the next time you hear any of these myths about index funds, remember to do your own research and not let emotions influence your investment decisions. Also, while investing, remember to keep emotions out of investment decisions, invest for the long term, be patient, and accept that there will be market corrections from time to time.