What are index funds?

A key advantage offered by mutual funds over directly investing in the financial market is the involvement of an expert in managing the investment. The fund manager designs the portfolio, monitors it and makes trades to potentially optimise returns. The chief objective is to outperform the broader market in the long term.

This is known as an active investment style. However, some types of mutual funds also follow a passive strategy, where the goal is not to beat the market but to match its returns. One such fund is the index fund.

These funds mirror the portfolio of a particular market index, such as the S&P 500 or Nifty 50, by including the same securities in the same proportion as the benchmark index.

This article will help you understand what index funds are, their pros and cons in comparison to active mutual funds, and the factors you should weigh when including them in your portfolio.

• Table of contents

1. Understanding index mutual funds
2. How do index funds work?
3. Index funds: An example
4. Types of index mutual funds
5. Who should invest in an index fund?
6. Benefits of index funds
7. Factors to consider before investing in index funds

Understanding Index Mutual Funds

There are several index fund options in India. Some are equity funds, some are based on debt market indices. There are also index funds following sectoral indices (such as Nifty Bank and Nifty Auto), or strategy indices (such as value or momentum-based indices). In each case, the portfolio mirrors that of the benchmark index, and the aim is to replicate the performance of wider market in that segment. However, returns are subject to tracking error – a difference between the benchmark index’s performance and that of the index fund.

This passive investment approach offers several advantages. By replicating an established index, index funds inherently provide broad exposure and diversification benefits. Additionally, since they don't require extensive research or active trading, they tend to have lower expense ratios compared to actively managed funds.

For investors seeking a simple and cost-effective way to participate in the market, index funds can be an attractive option. Some investors may also find index funds less risky, as there is no management risk – the risk that a fund manager’s decisions could negatively impact returns. They offer a straightforward approach to investing in a diversified portfolio that closely tracks the performance of a chosen market segment.

How do Index Funds Work?

Index funds follow a systematic process. Here's how they work:

1. Index selection: The fund manager identifies a benchmark index, such as the Nifty 50, Sensex, or another index that aligns with the fund's investment objective.
2. Portfolio construction: The fund then invests in all the securities within the index. For instance, an index fund tracking the Nifty 50 will hold the same 50 stocks in proportions that match their respective weights in the index.
3. Passive management: Unlike actively managed funds where fund managers actively select stocks, index funds follow a passive management approach. The fund manager only makes changes to the portfolio if the underlying index undergoes changes.
4. Tracking the index: The net asset value of the index fund fluctuates in tandem with the performance of the underlying index, subject to tracking error. If the index rises, the fund's value increases, and vice versa.
5. Cost efficiency: Due to the passive management strategy, index funds generally have lower expense ratios compared to actively managed funds. This means that a larger portion of your investment is working for you, potentially leading to higher returns over time.

Understanding Index Funds with an Example

To better understand how index funds work, let's consider an example based on the Nifty 50 index. This index tracks the performance of the 50 largest companies listed on the National Stock Exchange of India.

A Nifty 50 index fund would invest in all 50 stocks that constitute the index. The fund manager wouldn't attempt to pick individual "winning" stocks; instead, they would allocate the fund's assets in proportion to each company's weightage within the index. This means that larger companies would hold a larger percentage of the fund's portfolio, while smaller companies would have a smaller share.

By investing in this Nifty 50 index fund, you essentially own units representing fractional shares of each of the 50 companies included in the index. This provides instant diversification across various sectors and companies, reducing the risk associated with investing in individual stocks.

Types of Index Mutual Funds

Index funds come in various forms, based on the different types of indices in the market. These include:

1. Broad based indices: These indices offer exposure to a wide array of stocks across sectors. These include Nifty 50, Nifty 100 or Nifty 500. There are also broad-based indices focusing on mid cap or small cap stocks.

2.  Equal weight indices: Unlike market capitalization-weighted index funds, equal weight indices give equal weightage to each stock in the index.

3.  Sector-based indices: These indices concentrate on specific industry sectors, such as banking, technology, or healthcare.

4.  Strategy indices: These indices pick stocks based on certain characteristics or factors. These could include value stocks, momentum stocks, low volatility stocks, among others. Examples include Nifty500 Value 50, Nifty200 Momentum 30 and Nifty100 Quality 30, among others.

Who Should Invest in an Index Fund?

Index funds are ideal for these investors:

1. Passive investors: Those who prefer a hands-off approach to investing and seek potential returns in line with broader market trends.

2. Cost-conscious investors: Individuals looking to minimise investment costs, as index funds typically have lower expense ratios compared to actively managed funds.

3. New investors: Newcomers to the investing world who seek a straightforward and easy-to-understand investment option with broad market exposure.

4. Diversification seekers: Individuals aiming to achieve instant diversification across a specific market segment without the complexities of stock picking.

5. Investors seeking lower risk: Those who prefer returns similar to the broader market's performance, rather than chasing potentially higher returns through actively managed funds.

Benefits of Index Funds

Here are some advantages offered by index funds:

1. Cost efficiency: Index funds typically have lower expense ratios than actively managed funds.

2. Accessibility: Investing in index funds doesn't require in-depth financial knowledge or stock-picking expertise.

3. Diversification: Index funds offer instant diversification by providing exposure to a broad range of stocks or bonds within a specific market segment.

4. Time saving: With index funds, investors can save valuable time and effort as they don't need to research individual stocks or constantly monitor market trends.

5. Minimal fund manager bias: Since index funds replicate a predetermined index, they are not subject to biases or decision-making that can sometimes affect actively managed funds.

Factors to Consider Before Investing in Index Funds

If you are investing in index funds in India, these are some of the factors you should consider:

1. Risk and return potential: Index funds carry market risk and are subject to volatility, especially equity-oriented ones. If you have a longer-term horizon and can withstand short-term volatility, equity index funds can be a suitable choice. For short-term investments, you can consider debt index funds.

2. Expense ratio: Choose index funds with lower expense ratios to optimise your investment's return potential.

3. Investment objective: Clearly define whether you seek capital appreciation, the minimal impact of volatility, or potential for regular income. For example, a Nifty 50 index fund might be suitable for growth, while a bond index fund could provide regular income.

4. Choice of index: Research different indices and their historical performance before making a decision. Choose an index that represents the market segment you want exposure to.

5. Tracking error: Evaluate the fund's tracking error, which measures how closely it replicates the underlying index. Lower tracking error indicates better replication and potential returns closer to the index.

6. Diversification: Consider diversifying your portfolio by investing in multiple index funds tracking different market segments to spread risk further.

FAQs

Is an index fund good or bad?

Index funds are neither inherently good nor bad; their suitability depends on your individual investment goals and risk tolerance. If you seek broad market exposure, low costs, diversification, and a passive investment approach, then index funds can be an excellent choice. However, if you're looking for the potential to outperform the market and are willing to take on higher risks, actively managed funds might be more appealing.

What is the difference between index funds vs mutual funds?

Index funds are a type of passively managed mutual fund. They differ from active mutual funds in a few important ways. Index funds passively track a specific market index, while active funds have a portfolio with handpicked stocks. The fund manager designs the portfolio and makes changes to it as needed based on market movements and their strategies. Passive funds aim to match the market’s performance, subject to tracking error. Active mutual funds seek to potentially outperform the market.

What are the risks associated with index funds?

There are several risks associated with index funds. These include:
Market risk: Index funds are subject to the overall fluctuations of the market they track.
Tracking error: The fund's performance may not perfectly match the index due to factors like expenses and trading costs.
Index-specific risk: The chosen index might not perform as well as other indices or the broader market.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.