When it comes to investing, different investors have different goals, risk tolerance, and investment styles. Some investors prefer to actively manage their investments, deciding which stocks, bonds, or other asset classes to buy or sell to maximise returns. Others prefer a passive approach, choosing index funds as a way of diversifying their portfolio without the need for constant monitoring and decision-making.
While index funds give investors exposure to different stocks with minimal effort and expense, comparing them is an essential step for making the right investment decisions. From considering performance history, tracking error, and expense ratio to potential risks and rewards, let’s learn how to compare different index funds and invest wisely for your financial goals.
- Tracking error
Tracking error measures how closely an index fund follows its corresponding market index. It’s calculated by subtracting the portfolio return from the return of the benchmark index over a given period of time. A lower tracking error is better because it means that the fund is following its benchmark more closely. If a fund has a high tracking error, then it may be underperforming or taking too much risk relative to its benchmark.
- Volatility
Volatility measures how much an investment fluctuates over time, in other words, how much risk it carries with it. When comparing different index mutual funds, look at each fund’s volatility relative to its benchmark index and other similar investments. If one fund has significantly higher volatility than another, then it means that there’s more potential for large gains or losses, which could be good or unfavourable depending on your goals and risk tolerance.
- Past performance of at least 3-5 years
While short-term performance can give you an idea of how the mutual fund scheme is currently performing, looking at longer-term data will provide more insight into its historical returns. This information will allow you to see how the fund has performed during bull and bear markets to better understand what type of return you can expect over time.
- Risk level
Index funds can be debt or equity funds, and their risk level can vary depending on the type of index they track. Debt index funds typically include safer and more conservative investments than index funds holding equity and equity-related instruments. However, equity mutual funds tend to have higher returns because of their volatile and risky nature.
Consider your risk appetite and decide whether you want to take on more or less risk with your investments.
- Company size and capitalization
Small-cap indexes typically include younger companies with higher potential for growth but also higher risk. Mid-cap indexes usually include established companies that have already achieved some success but are still growing at a good pace. Large-cap indexes usually include blue-chip companies that have been around for many years and offer stability but less growth potential than small and mid-cap funds.
Based on whether you prefer high risk, high growth of small-cap funds, stability and consistent returns of large cap mutual funds, or want both through mid-cap funds, thorough research is crucial in selecting the index funds that best align with your financial objectives.
Final words
With instant diversification across different asset classes and sectors, low management fees, and easy performance tracking, index funds can be a valuable addition to any investment strategy. And comparing index funds can further help you create a diversified portfolio that is well-equipped to weather market fluctuations while still delivering consistent returns.
Additionally, you can set up a systematic investment plan (SIP) in index funds to eliminate market timing and steadily grow your wealth with regular contributions. However, don’t forget that different index funds have different risks and investment strategies, so having guidance from a financial advisor is essential to optimise your portfolio for long-term success.
