Index funds and associated risks

A mutual fund is a professionally managed company that collects money from many investors and invests it in securities such as stocks, bonds and short-term debt, equity or bond funds and money market funds.

Mutual funds are a good investment for investors looking to diversify their portfolio. Instead of betting everything on one company or sector, a mutual fund invests in different stocks to try to minimize portfolio risk.

The term is typically used in the US, Canada and India, while similar structures around the world include the SICAV in Europe and the open-ended investment firm in the UK.

Index funds and associated risks

Index funds are passively managed mutual funds that simply copy a popular market index such as Sensex or Nifty. While index funds carry relatively less market risk than actively managed funds, the fund manager has limited ability to manage acute corrections because the fund must hold all securities in the index in the same proportion. It can no longer buy undervalued stocks or sell overvalued stocks to take advantage of these market corrections.

Because index funds track specific market indices, they end up with a portfolio of consolidated stocks within a specific market segment, be it large capital, small caps, multicaps, bank stocks, corporate bonds, etc. Therefore, they limit the investor’s selection universe.

Despite imitating a market index, these funds do not provide the same return as the market index due to the presence of a tracking error. A market index does not involve any cost when it undergoes a change in composition, that is, when a certain security is added or removed from it. An index fund must bear the transaction cost to ensure that its portfolio reflects that of the index. In addition, there may be a delay when stocks or the weight of individual stocks in an index undergo some change. This reduces the performance of the Index Fund relative to its index return.

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