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Index Funds- Basics of Index Funds, Its Features and More

Diversification is the key to building a successful investment portfolio. Index mutual funds can help you effectively achieve this diversification. Read this post to know what they are, how they work, and who should invest in them.

Equity is one of the most rewarding asset classes. But when building an equity portfolio, it is necessary to spread your investment across industrial sectors. This spreading of investment or 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 will help keep the risk to a minimum. This makes diversification an integral component of every successful investment portfolio. But selecting quality stocks across industries is something that even most professional investors find challenging. If you don't possess extensive investment knowledge and experience, an index fund can help you achieve effective diversification.

Take a look at what these funds are, how they work, their features, and who should invest in them.

What are Stock Indexes?

Before talking about index funds, one should first understand what an index means. 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 might have at least heard the term 'Sensex' and 'Nifty'. They are the two most popular stock indices in India. There are other indices such as BSE 100, BSE Bankex, Nifty Next 50, Bank Nifty, and more.

Now, these two indices are a measurement of the entire Indian stock market. They are made up of 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, and more. 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 is an index fund.

What are Index Mutual Funds?

Index funds are those mutual funds that 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. So, an index scheme that follows Nifty 50 will spread your investment across the same 50 stocks that Nifty 50 tracks.

Similarly, a fund that tracks Sensex will have investments in the same 30 stocks, which the benchmark index measures. Even the composition or proportion in which the investment is spread is similar to the benchmark index.

For instance, Nifty 50 has around 31% exposure to the Banking/Financial sector. So, index mutual funds that track Nifty 50 will also have 31% of its portfolio invested in the Banking/Financial sector and in the same stocks that are included in the benchmark index.

Working of Index Mutual Funds

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

But index schemes follow a 'passive' investment style. Here, the fund manager is not required to search for profit-making opportunities consistently. The goal of index funds is to match the composition and performance of the index it is following. This also means that, technically, the returns generated by these funds is similar to the returns generated by its index.

For instance, let us assume that 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 index scheme that follows Nifty 50. Technically, the returns that you and other investors will generate in a year should be the same.

Tracking Error in Index Mutual Funds

While the fund manager tries to make sure that the returns generated by the fund are equal to that of the benchmark index it follows, there can be slight differences at times. This is known as the 'tracking error'.

The fund manager must try and make sure that the tracking error is kept to a minimum so that the returns generated by the fund is similar to what the index delivers.

Benefits of Investing in Index Mutual Funds

Here are some of the top reasons why one should consider investing in index funds-

  • Lower Expense Ratio-

    As these funds are passively managed funds, their expense ratio is one of the lowest. In most cases, the expense ratio of index funds is 0.50%. Actively managed funds have an expense ratio in the range of 1.5%-2.5%.

  • 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 to benefit from multiple industrial sectors.

  • Investment Only in Quality Stocks-

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

Who Should Invest in Index Mutual Funds?

These funds are suitable for individuals who are not comfortable with the risk level of actively-managed equity funds. But just like any other type of equity funds, it is recommended that one should remain invested in index schemes for at least 3-5 years to generate considerable positive returns.

But if you aim to generate higher market-beating returns, it'd be better if you go with a quality actively-managed equity fund. Also, if you are not comfortable with any risk at all, debt funds like fixed-income funds or liquid funds can be a better choice. While index funds are generally known to be safer than actively-managed equity funds, they do carry a certain level of risk.

You can consult an investment advisor to help you make the right decision. Just like any other investment, do adequate research and focus on factors like your investment objective, risk appetite, and investment horizon before making a decision.