How to select index funds?

Indices have shown its negative side in March 2020, when it nosedived around 30 per cent thereby, eroding investors’ wealth. However, it has shown a quick recovery in the month of April 2020. This has made investors prefer index funds as they feel valuations are cheap enough. However, an important thing to note is that we are still not out of the bear phase. The recent recovery can be termed as a ‘dead cat bounce’. Hence, it is better to invest in a staggered manner either via systematic investment plan (SIP) or parking lumpsum in liquid fund and doing systematic transfer plan (STP) from it. A significant question might pop-up here, i.e. how to select index funds? One might think it is fairly easy but there are a few things that need to be kept in mind before selecting index funds.

Tracking error

This is one of the major factors that should be considered while investing in index funds. Tracking error is nothing but a standard deviation of the daily returns of fund and index that it is tracking. The index fund manager’s job seems to be a cakewalk, as there is no active fund selection activity involved but usually, that’s not the case. The fund needs to account for corporate actions like stock splits and dividends as well as to ensure that the weights of the individual stocks in the portfolio should match with that of the index. Also, there are expenses that need to be taken care of. Hence, the NAV movement of index funds would lag with respect to its underlying index. A good fund manager would try to minimise this risk. Hence, the index funds, whose historical trends show consistency in maintaining minimum tracking, would be the ideal index fund to invest in.

Expense ratio

This is one of those things that would help you get better returns over the long-run. So, lower the expense ratio, better it is. Hence, while investing in index funds, invest in those funds that have a lower tracking error as well as a lower expense ratio. The lower expense ratio will insure better returns.