Diversification is the key to a sound investment portfolio. It aims to protect your portfolio from an adverse
performance by a particular asset class, helping your portfolio stay sound. As an investor, you can try to
disseminate your funds throughout asset classes like debt, equity, real estate, gold, etc. Also, within every asset
class, you may try to diversify more to lower the risks. An index fund is an investment vehicle you can use to
achieve this goal.
Read on to know index funds' meaning, benefits, different types, and how to invest in them.
What is an index fund?
Index funds are portfolios of bonds or stocks imitating the performance of the financial market index. Such funds
replicate a portion of the stock market and, at times, the market itself. The funds are managed passively, which
means your fund manager may park funds in the same list of securities as in the underlying fund index. They do not
change the composition of the portfolio. Index funds track the performance of the underlying index.
How does an index fund function?
It is vital to remember that index funds track specific indices and are not managed actively, which is why they
incur low expenses. As they follow the market index, they may not outperform the market. They assist in balancing
the market-linked risks in your portfolio.
Let us understand this using an example. If an index fund tracks the NIFTY50 index, the fund portfolio will contain
50 stocks that constitute NIFTY50 Index in the same proportions. The index's portfolio will sometimes imitate the
underlying index, even in percentage holding. Owing to such correlation, the index fund's Net Asset Value (NAV) may
move with the index it is tracking.
Well-performing index mutual funds often aim to generate the same returns as their underlying benchmark. But even if
index funds mirror the market movements, returns can be slightly lower than the index it is tracking.
This is owing to the variation called 'tracking error'. Outflows and inflows in the fund, corporate actions, changes
in the index constituents, and cash levels in the fund affect tracking errors. Thus, when zeroing on the index
mutual fund, it is best to ensure that its tracking error is minimal.
Index funds’ benefits
• Low fees
As an index mutual fund imitates its underlying benchmark, there's zero need for research analysts to assist fund
managers in selecting the correct stocks. Also, there's zero active stock trading. All such parameters result in low
managing costs of index mutual funds.
• No bias investing
Index mutual funds follow a regulation-based and automated investment method. The fund manager is given a defined
mandate of the amount that must be invested in the index funds of different securities. It eliminates any bias or
discretion while making investment decisions.
• Simple to manage
Fund managers do not need to worry about how the stocks on the index are performing, making index mutual funds easy
to manage. A fund manager must only rebalance the fund portfolio periodically as per the timeline prescribed by SEBI
from time to time.
Types of index funds
• Broad market index funds: Broad market index funds capture a large segment of the investible stock. It is well
suited for you if you want to opt for a basket with a distinct variety of bonds or shares.
• International index funds: International index funds offer global exposure. They are not restricted to any stock
market or country, providing you exposure to global/international companies in frontier or emerging markets.
• Market capitalisation funds: If you have a long-term investment timeframe, you can benefit by investing in market
capitalisation funds. They endow increased exposure to a wide basket of Large, mid and small-sized companies.
• Bond-based index funds: Bond-based index funds can assist you in maintaining a balance combination of long, medium
and short-term bond maturities, which yields steady revenues.
• Earning-based index funds: These index funds work based on the earnings or profits of a company. There are two
kinds of company indices – value index and growth index. The value index contains stocks that trade at a lower cost
than the company's earnings. Growth indices contain businesses that are anticipated to generate quick profits than
the rest in the market.
How to invest in index funds?
For investing in index funds, you must follow the below stepwise process:
• Sign in through a secure app or website to invest in a mutual fund
• Finish the KYC process
• Post KYC process completion, select the index fund of your preference based on your financial objectives and risk
• Once you have selected the index funds to invest in, transfer the appropriate amount into the funds
Index mutual funds could be an excellent way to start investing if you are new to market investing. They are
cost-effective and attract minimum effort. Less volatility and predictable results in index funds also serve as an
added advantage if you are a risk-averse investor.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.