What are Index Funds? And how do they work?

What is an Index Fund?

First, let’s understand the index fund meaning. An index mutual fund scheme is a type of mutual fund scheme that allocates investments into stocks or permissible securities that mirror the index to be followed, such as the Nifty 50 or BSE Sensex. These are passively managed funds as the fund manager invests in the same securities and tries to closely match their proportions as that in the underlying index without altering the portfolio composition. Generally, the objective of these funds is to aim to provide returns that are closely commensurate with the performance of the tracked index, subject to tracking errors. Now that we know what is an index fund let’s see how it works. 

How does an Index Fund Work?

An index fund can be an equity index fund which shall generally invest in equity and equity-related instruments. It may also be a debt index fund where investments would generally include debt instruments. The index fund investment strategy can ensure it invests in all the securities tracked by the benchmark index. Unlike actively managed mutual funds that strive to outperform their benchmark, index funds passively aim to closely commensurate the returns provided by the underlying index, subject to tracking errors.

Who can invest in Index Funds?

Index funds are passively managed and only mirror an underlying index. These can be considered by investors looking to obtain a diversified portfolio that passively tracks an index. These can be considered by investors who don’t want to directly invest in individual stocks but would like to gain exposure to a broader market. 

Key aspects of index investing: 

Lower expense ratio: Since Index funds are passively managed, they do not require extensive research or active trading; consequently, the managing expenses associated with index funds are relatively low.

Investment approach:  Index funds adhere to an investment strategy based on regulations and generally mirror a benchmark index. Fund managers are provided with a predetermined mandate specifying the allocation of funds across various permissible securities. This approach eliminates active human discretion and bias when making investment decisions.

Extensive market exposure: Index investing provides for a portfolio with exposure across multiple sectors and stocks. This allows investors to capture a broad segment of the market through a single index fund. 

Managing index funds generally involves only mirroring the respective benchmark index. The fund manager builds a portfolio whose holdings mirror the securities of a particular index to be followed. There is usually no active stock picking/stock selection research involved. 

Risk Factors to consider before planning for investments in Index Funds in India:

Similar to any investment in other types of mutual fund schemes, index investing also carries a level of risk. These are:

1. Lack of Flexibility: Index funds may have limited flexibility to respond to price declines in the securities comprising the index.
2. Tracking Error: Tracking error means the extent to which the Net Asset Value (“NAV”) of the index fund moves in a manner inconsistent with the movements of the benchmark index on any given day or over any given period of time due to any cause or reason whatsoever. It is the annualized standard deviation of the difference in daily returns between the underlying index or goods and the NAV of the Index Fund.  
3. In addition to the above, there may be scheme-specific risk factors as may be provided for in respective Scheme information documents. The same should be read and understood carefully before making any investment decision. 

Conclusion:

The blog has attempted to explain what is an index fund. Index investing is a strategy of passive investment that involves putting money into an index fund. An index fund is a type of fund that aims to generate returns closely mirroring the performance of a specific market index, subject to tracking error. You can approach your financial advisor to learn how to invest in index funds and how to invest in mutual funds in general. You can also visit mutual fund websites for market and fund updates.

FAQ:

What is an example of an index fund?

There can be various types of index funds such as Broad Market Index Funds, Market Capitalization Index Funds, Equal Weight Index Funds, Factor-Based Or Smart Beta Index Funds, Strategy Index Fund, Sector-Based Index Funds, International Index Funds and Debt Index Funds. 

How do I invest in an index fund?

You can approach your financial advisor or a mutual fund distributor to help you to invest in index funds you are interested in. You can also apply directly with the mutual fund house or the asset management company that offers index funds as an investment option.

Can I set up a Systematic Investment Plan (SIP) in an index fund in India?

Yes, you can invest in index funds through SIPs. You can visit the official website of the mutual fund or take the help of a financial expert.

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