The stock market or the stock market reflects the growth of the economy of the country. And, if anyone wants to be a part of the growing Indian economy, one can get this opportunity by investing in the stock market.
Basically, there are two ways to invest in stocks. By directly buying shares of companies and another by investing through equity mutual funds. And the easiest way to invest in equity funds is passive investing or index investing.
Any mutual fund is either actively managed by a fund manager or managed by simply following any stock market index like Nifty50, Nifty Next 50, S&P BSE Sensex, etc.
Indices are meant to represent the performance of a large market, a market segment or factors that explain the performance of a market. For example, indices like Nifty50 or S&P BSE Sensex represent the performance of a broad market. An index like Nifty Bank represents the banking segment or S&P BSE Finance represents the financial sector of the market. Indices like Nifty200 Momentum 30 represent a momentum factor or S&P BSE Low Volatility represents a low volatility factor. Passive funds or index trackers attempt to replicate the performance of one of these indices.
Passive funds replicate the performance of an index by investing in stocks that are part of the underlying index and this too largely in the same proportion. Let’s understand this with an example.
Suppose there are three stocks in an index. Stock A, B and C. The weight of stock A is 50%, stock B is 25%, and stock C is 25%. In this case, if Rs. 100 is to be invested, Rs. 50 will be invested in stock A, Rs. 25 in stock B and balance Rs. 25 in stock C.
Now, if after one year this index gives a 15% return, the passive fund will also give a 15% return and if this index drops by 10%, the net asset value of the fund will also drop by 10%. However, due to fund costs and tracking error1, there will be little difference between index returns and fund returns.
Index funds and ETFs are inexpensive, straightforward and easy options for such a passive investment.
1The mandate of the passive fund is to closely track / replicate the underlying index. Any deviation or error in such tracking is called a tracking error. This is the annualized standard deviation of the difference between the returns generated by the plan and the returns generated by the underlying index on a daily basis.
An investor education initiative by UTI Mutual Fund
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