How to choose the best index funds for your investment? Expert shares 3 strategies for building a winning portfolio

Index funds are mutual funds that invest in various stocks within a specific market index. They've long been regarded as one of the best ways to invest. Through diversification, these funds lower overall risk by giving access to thousands of assets in a managed investment.

Low management costs are the main benefit of investing in index funds. They can give broad market exposure at low costs because they follow their underlying benchmark and don't need a group of research experts to choose stocks.

Understanding the underlying index's risk-reward profile is essential before investing in index funds. Shaily Gang, Head of Products at Tata Asset Management, explains how indices are constructed and offers three key principles for choosing the right funds: aligning with your risk tolerance through strategic and tactical allocation, minimising tracking errors and expenses, and considering the fund's asset size.

In a conversation with Livemint, Shaily Gang listed three principles investors should follow when choosing index funds.

1) Choose funds under two buckets

Index fund selection should align with your risk tolerance. This is especially important when deciding between strategic and tactical approaches.

Risk Assessment: Indices covering specific sectors, sub-segments, or including mid-and small-cap stocks typically have higher standard deviations.

Standard Deviation: This metric quantifies an index's risk level; a higher standard deviation signifies greater volatility and risk.

Investors who want lower or moderate risk rewards may look at the following under the Strategic bucket.

• Large-cap or flexi-cap market exposure indices
• Bullion indices
• Factor indices with a smaller universe (e.g., 200 stocks)
• Broad thematic funds (e.g., Manufacturing, Infrastructure, Business Groups)

Investors fine with higher-risk reward avenues, may look at the following under the Tactical bucket.

• More narrowly focused thematic index funds (e.g., Capital Markets within Financial Services, Tourism within Consumer Discretionary)
• Factor indices focused on mid-and small-cap stocks.

2) Choose index funds with low tracking difference, low tracking error and low expense ratios

Investors should know that an index fund's performance won't perfectly mirror its index. This is due to trading costs, portfolio adjustments (rebalancing and reconstitution), and the fund's operating expenses. Look for funds that effectively manage these factors to ensure minimal tracking difference, tracking error, and low expense ratios, maximising your returns.

3) Choose funds with relatively higher AUMs

Larger funds experience minimal impact from daily investor activity (subscriptions and redemptions) because these flows represent a smaller percentage of their total assets under management (AUM).

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Disclaimer: The views and recommendations made above are those of individual analysts, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.