What is Index Fund ?

5paisa Research Team Date: 18 Jul, 2023 11:11 AM IST


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Index funds have long been considered one of the smartest investment choices one can make. Apart from being affordable and less risky, index funds enable diversification and generate attractive returns for investors over a period of time. 

This post will discuss everything you need to know about index funds, including their benefits, risks, and more


Watch Mutual Funds or Index Funds? Which Is Best For Investing?


What is an Index Fund?

An index fund is a specialized mutual fund that buys the same stocks as in a particular market index. A market index is a hypothetical portfolio of stocks and securities that represents a section of the market. For instance, the S&P 500 index represents 500 of the largest U.S. companies.
Among the key features of an index mutual fund include-

  • The fund imitates the portfolio of an index and is also known as an index-tracked mutual fund.
  • Index funds are passively managed as the key objective of these funds is to track and imitate the performance of a popular stock market index such as NSE Nifty 50 and S&P BSE Sensex.
  • The asset allocation in the case of an index fund is the same as that of its underlying index, which is why the returns offered by these funds are comparable with their underlying index.
  • The average annual return for the S&P 500 index is close to 10% over the long term. However, it is important to note that the performance of the S&P 500 index is better in the long term as compared to others.

The Working of an Index Fund

Being a special type of financial vehicle that collects money from various investors and invests it in stocks or bonds, an index fund tracks the returns of a chosen stock market index.
Because index funds track a particular type of index, they come under passive fund management, where the traded stocks and securities work as per the underlying benchmark. Apart from this, this fund is not dependent on the expertise of investors to find suitable stocks for investment.
Unlike an actively managed fund that works as per the market, an index fund matches the performance of its index. This is why index funds' returns align with their underlying market index. 

Who Should Invest in Index Funds?

When it comes to investing in a mutual fund, the decision primarily depends upon factors such as risk preference and the respective financial goals of an investor. Based on this, index funds are most suited for risk-averse investors with predictable returns expectations.
One of the highlights of index funds is that you do not have to track these funds extensively. For instance, if you wish to invest in equities without taking much risk, you can choose a Sensex or Nifty index fund. These funds give you decent returns that match the upside of that particular index. 

Advantages of Index Funds

Index funds are one of the most straightforward ways to build wealth. By simply matching the benchmark performance of the financial markets over time, index funds can allow investors to turn their investment into a huge asset.
Here are some of the reasons why investors find index funds beneficial:

  • Low Fees

One of the key advantages of index mutual funds is their low fees. Unlike index funds, actively managed funds have much higher fees and lower returns than the market. That's because an index fund manager has to simply buy the stocks or other investments in an index without you having to pay them.

  • Investing Experience Not Needed

Index funds don't require any business knowledge or stock picking; therefore, they are suitable for everyone with money to save and invest.

  • Huge Variety of Investment 

Index funds are available for various investments. You can buy anything from stock index funds and bond index funds, two of the most popular investment strategies. Besides, you can also purchase other focused index funds that target specific financial market areas.

  • Saves Time

Index fund investments save a lot of time. Based on the type of index funds you choose, you’ll spend anywhere from a few minutes to a few hours per year. This is because, with index funds, you minimize your time spent researching individual stocks and simply can allow the fund's portfolio manager to invest in an index that already includes the stocks you wish to invest in.

  • Pay Less in Taxes

Index funds are quite tax-efficient than several other investments. For instance, you get the advantage of no long term capital gains as you don't need to buy and sell your holdings.

  • Simple to Manage

Index finds are much simpler to manage than other funds because fund managers do not need to track how particular stocks on the index are doing. Instead, fund managers are only required to rebalance the portfolio from time to time.

Risks Associated with Index Funds

In general, an index fund will see similar risks associated with the stocks and securities in the particular index it tracks. Apart from this, the fund may also be subject to various other types of risks including-

  • Less Flexibility

Compared to a non-index fund, an index fund is less flexible in how it performs against the price declines in the securities of a particular index.

  • Underperformance of Stocks

An index fund, in most cases, may underperform its index because of factors such as trading costs, fees and expenses, and tracking errors.

  • Investment Horizon

Index funds can undergo a lot of fluctuations in a short period. If they last long, these fluctuations can average out all the gains that your investment has earned. This is also why index funds are best suited for long-term investors who allow the fund to perform at its maximum potential.

  • Tracking Errors

Another risk associated with index funds is tracking error. This means that in certain cases, an index fund may not track its index accurately. For instance, a fund may only invest in a sample of the securities in the market index. This affects the fund’s performance which will be less likely to match the index.

How to Invest in Index Funds?

Here is the detailed process you can follow to invest in index mutual funds-
1. Choose an index
The first step is to pick an index from a range of different indexes you can track using index funds. Among the most common ones is the S&P 500. Some of the other top indexes based on various parts of the market they cover include-

Apart from these indexes, there are many sector indexes that are related to specific industries, style indexes that target fast-growing companies, and country indexes that target stocks in single nations.
2. Pick the correct fund
After picking an index, you need to look for at least one index fund that tracks it. In the case of popular indexes (such as the S&P 500), however, there may be several options all tracking the same index.
If there is more than one index fund for your chosen index, you will need to ask the following questions to make the right decision.

  • Which is the index fund that most closely tracks the index's performance?
  • Which index fund costs less? 
  • Are there any factors preventing you from investing in the fund? 

Answering these questions makes it much simpler to choose the appropriate index fund.
3. Buy index fund stocks
To be able to buy index funds, one option is to open a brokerage account through which you to purchase and sell shares of the index fund you wish to invest in. The other option is to go directly through the fund house that provides the chosen index fund.

Your Guide to Choosing an Index Fund

Here is how you can choose an index fund-

  • Don't choose your index funds based on small expense ratios, as these are temporary attractions to entice investors in AUM.
  • Choose a fund with a high AUM of at least Rs 1000 cr as a low AUM can lead to tracking errors.

Always measure the tracking error in terms of the difference between the index and fund.


To Wrap up

Index funds are an excellent choice that offers investors of varied skill levels a simple yet successful way to invest. As a mutual fund investor, if you're interested in growing your money but not willing to do a lot of research, index funds are a great solution to achieving your respective financial goals.

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