Index Funds

How do index funds work?

The idea is straightforward: an index fund creates a portfolio that mirrors that of the benchmark index. It invests in the same securities in the same weightage as the benchmark.
If the constituents of the benchmark change, the fund manager alters the portfolio. Because there is no active stock selection, expense ratios are relatively low. However, slight discrepancies can arise between the fund’s performance and that of the index. This difference is known as the tracking error.

Types of index funds

Index funds can broadly be classified based on the type of indices they track. These can include Large cap index funds: Follow large cap indices such as Nifty 50, Nifty Next 50, or BSE Sensex.
Mid cap and small cap index funds: Track indexes such as Nifty Midcap 150 or Nifty Smallcap 250.
Sectoral and thematic index funds: Track specific sectors such as banking or IT.
Bond index funds: Track fixed-income instruments rather than equities, making them relatively low risk.

 

 

1. Identify the type of index fund: This may be a broad market index fund, a bond index fund, a strategy index fund or a sectoral index fund, among others.
2. Select a scheme:Identify the various asset management companies offering the scheme. Assess the company’s credentials and compare schemes based on tracking error, expense ratio and the fund manager’s track record.
3. Choose between lumpsum and SIP: Make a one-time lumpsum investment or invest in installments through a Systematic Investment Plan (SIP).
4. Make the investment: You can invest directly through the asset management company offering the scheme or through a mutual fund distributor.