What is Index Fund ?
5paisa Research Team
Last Updated: 18 Jul, 2023 11:11 AM IST
Want to start your Investment Journey?
Content
- Introduction
- What is an Index Fund?
- The Working of an Index Fund
- Who Should Invest in Index Funds?
- Advantages of Index Funds
- Risks Associated with Index Funds
- How to Invest in Index Funds?
- Your Guide to Choosing an Index Fund
- To Wrap up
Introduction
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-
- Large stocks (US)
- Small stocks (US)
- International stocks
- Bonds
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.
More About Mutual Funds
- NPS vs ELSS
- XIRR vs CAGR: Understanding Investment Return Metrics
- SWP and Dividend Plan
- What is Solution Oriented Mutual Funds?
- Growth Vs Dividend Reinvestment Option
- Annual vs Trailing vs Rolling Returns
- How to Get Capital Gain Statement for Mutual Funds
- Mutual Funds Vs Real Estate
- Mutual Funds vs. Hedge Funds
- Target Maturity Funds
- How to Check Mutual Fund Status with Folio Number
- Oldest Mutual Funds In India
- History Of Mutual Funds In India
- How To Redeem ELSS Before 3 Years?
- Types of Index Funds
- Who Regulates Mutual Funds In India?
- Mutual Fund Vs. Share Market
- Absolute Return in Mutual Fund
- ELSS Lock in Period
- Treasury Bills Repurchase (TREPS)
- Target Date Fund
- Stock SIP vs Mutual Fund SIP
- ULIP vs ELSS
- Long Term Capital Gain Tax on Mutual Funds
- Smart Beta Funds
- Inverted Yield Curve
- Sinking Fund
- Risk-Return Trade-Off
- Registrar and Transfer Agents (RTA)
- Mutual Funds Overlap
- Mutual Fund Redemption
- Mark to Market (MTM)
- Information Ratio
- Difference Between ETF and Index Fund
- Difference Between Mutual Fund and Index Fund
- Top 10 High Return Mutual Funds
- Passive Mutual Funds
- Passive Funds vs Active Funds
- Consolidated Account Statement
- Mutual Funds Minimum Investment
- What is Open Ended Mutual Fund?
- What is Closed End Mutual Fund?
- Real-Estate Mutual Funds
- How to Stop SIP?
- How to Invest in SIP
- What is a Blue Chip Fund?
- What is XIRR in Mutual Funds?
- What is a Hedge Fund?
- Tax Treatment of Long Term Capital Gains
- What is SIP?
- NAV in Mutual Funds
- Advantages of Mutual Funds
- Stocks vs Mutual Funds
- What is STP in Mutual Fund
- How Mutual Fund Works?
- What is Mutual Fund NAV?
- What are Mutual Funds?
- Mutual Fund Cut Off Time
- Mutual Fund the Best Investment Option for Conservative Investors
- Advantages and Disadvantages of Mutual Funds
- How to Choose Mutual Funds in India?
- How to Invest In Mutual Funds?
- How to Calculate NAV of Mutual Fund?
- What Is CAGR In Mutual Funds?
- What is AUM in Mutual Fund
- Total Expense Ratio
- What is XIRR in Mutual Funds?
- What is SWP in Mutual Fund
- How to Calculate Mutual Fund Return?
- Gold Mutual Funds
- Tax On Mutual Fund Investment
- The Top Benefits and Drawbacks of The Rupee Cost Averaging Approach
- How to Start a SIP Investment?
- What Is SIP & How does SIP Work?
- Best SIP Plans for Long Term: How and Where to Invest
- Best SIP Mutual Fund Plans
- ELSS Vs SIP
- Top Fund Managers in India
- What is NFO?
- Difference Between ETF and Mutual Fund
- ULIPs VS Mutual Funds
- Direct Vs. Regular Mutual Funds: What’s The Difference?
- ELSS vs Equity Mutual Fund
- NPS vs Mutual Fund
- Can NRIs Invest in Mutual Funds?
- Mutual Funds Categorisation In India
- Everything You Need to Know About Small-Cap Funds
- What is Public Provident Fund ?
- What is Large Cap Mutual Fund ?
- What is Index Fund ?
- What is IDCW in Mutual Fund ?
- What is Hybrid Fund?
- What is Gilt Fund ?
- What is ELSS Fund ?
- What is Debt Funds?
- What is an Asset Management Company - A Thorough Explanation
- What are Mid Cap Funds
- Liquid Funds - What are Liquid Funds?
- A Beginner's Guide to Investing in Fund of Funds Read More
Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing. For detailed disclaimer please Click here.