Index Funds: Basics of Index Funds, Features and More

Diversification is the key to building a successful investment portfolio. Among numerous financial instruments, you can use it to diversify; Index mutual funds can help you effectively achieve the diversification goals. Read on to know what they are, how they work, and who should invest in them.

An Overview

Equity is one of the most rewarding asset classes in terms of returns. However, when building an equity portfolio, it is necessary to spread your investment across various industrial sectors to minimise risk. This diversification helps you take advantage of all the different industrial sectors while also building a safety cushion for your portfolio.

If a particular industrial sector underperforms, your investments in other sectors help keep the risk to a minimum. However, selecting quality stocks across industries is challenging even for most professional investors. If you don't possess extensive investment knowledge and experience, an index fund can help you achieve adequate diversification without having to select individual stocks.

What are Stock Indices?

In simple words, a stock market index or stock index is a measure or indicator of the securities market. For instance, if you have never invested in equities, you may have at least heard the term 'Sensex' and 'Nifty'. They are the two most popular stock indices in India. Other indices include BSE 100, BSE Bankex, Nifty Next 50, Bank Nifty, etc.

These two indices are used to measure the entire stock market’s performance. They include stocks from all the popular industrial sectors. For instance, Nifty is an aggregate of 50 stocks from sectors like Banking/Finance, Technology, Oil & Gas, Automotive, Metals & Mining, Pharmaceuticals, etc. Similarly, Sensex is an aggregate of 30 stocks of various industrial sectors.

Now that you have a brief idea about what a stock index means, let us check out what an index fund is.

What are Index Mutual Funds?

Index funds mimic the composition of stock indices. In other words, index mutual funds invest your money in those stocks that are part of its benchmark index. For example, an index fund that follows Nifty 50 spreads your investment across the same 50 stocks that Nifty 50 tracks.

Understanding Index Funds

With other types of equity mutual funds available, the fund manager constantly switches between stocks of different companies to generate higher returns for the investors. In other words, these funds try to beat the market benchmark. This is known as an 'active' style of fund management.

However, index schemes follow a 'passive' investment style. The goal of index funds is to match the composition and performance of the index it is following. Hence, the returns generated by these funds are similar to those generated by its index. For instance, suppose you distribute Rs. 50,000 across all the different 50 stocks that are part of Nifty 50. Another investor invests Rs. 50,000 in an indexing scheme that also follows Nifty 50. Technically, the returns that you and other investors will generate in a year would be identical.

Tracking Error in Index Fund

While the fund manager tries to make sure that the returns generated by the fund mirror the benchmark index it follows, they can differ at times, known as the 'tracking error'. Every fund manager tries to ensure that the tracking error is kept to a minimum so that the returns generated by the fund are similar to what the index delivers.

• Lower Expense Ratio

  As these funds are passively managed, their expense ratio is one of the lowest. In most cases, the expense ratio of index funds is 0.50%.

• Effective Diversification

  If your goal is to diversify your investment portfolio, index mutual funds are one of the best options. It spreads your investment across a broad market segment for effective risk distribution and benefits from multiple industrial sectors.

• Investment Only in Quality Stocks

  Stock indices regularly remove the underperforming stocks and add ones that are performing better. Similar adjustments are also made by index funds to mirror their underlying benchmark.

Who should invest in Index Funds?

Index funds are suitable for individuals who are not comfortable with the risk level of actively-managed equity funds. However, just like any other type of equity fund, it is recommended that one should remain invested in index schemes for at least 3-5 years to generate considerable positive returns. While index funds are generally safer than actively-managed equity funds, they carry a certain level of risk. You can consult an investment advisor to help you make the right decision. Like any other investment, do adequate research and focus on factors like your investment objective, risk appetite, and investment horizon before making a decision.