Index funds are a type of mutual funds which mimic or track an underlying index. For example, an index fund that replicates the Nifty 50 will consist of stocks from the Nifty 50 index.
It is a passive style of fund management and aims to replicate the performance of the benchmark index. Let’s take a look at the kind of returns they offer.
Returns Potential
Index funds have the potential of offering robust returns over the long term. This is because stock markets tend to create wealth over a longer period of time. In fact, index funds could even outperform actively managed funds as they are cost-efficient and eliminate the role of human bias.
However, one must also take into account the tracking error. Whenever index funds have to remove or add securities, they have to bear the transaction costs to keep the composition similar to the index. Also, the fund’s decision to keep some money, in case of redemption, could also lead to tracking error.
All of this leads to a reduction in the returns the index fund gives compared to the returns given by its benchmark index.
Understanding with an example
Let’s take a look at the example of index funds, which replicate the Nifty50 index. Currently, there are more than 15 such passive index funds.
The Nifty50 index has witnessed volatile times like – from the 2000 dot-com bubble to the pandemic-led collapse in 2020. However, it has managed to rebound and deliver robust returns.
Since its inception in 1995, this benchmark index has provided a return of around 11% annually, on an average. Even if we look at the returns over the last 5 years, the Nifty50 companies have delivered a return of 10.5%.
This shows that index funds have the potential of providing robust returns over the long-term horizon.