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WHAT IS AN INDEX FUND


Many investors who are new to the market aren’t aware of index funds (IFs). But as an investor, it is smart to know about all types of funds to choose from, before you make an investment. This will help you choose instruments that best suit your requirements and financial goals.

To help you make a more informed choice, we have outlined everything you must know about index funds in India. Starting with the definition, you will find out how the fund works, its types, objectives, who should invest in this fund and how it is different from an active fund. You will also learn about the reasons to invest in such a fund and get some investment tips.

WHAT IS AN INDEX FUND?

An index, like the Nifty or Sensex, is made up of a set of securities. These securities are held in different proportions (for example, stock A may contribute 8% weight to the index, stock B may contribute 12% and so on). An index fund is a mutual fund that has a portfolio which mirrors the components of market indexes.

Index funds in India provide broad market exposure at low operating costs. These funds follow specific rules and standards that do not alter whatever the state of the market is. Most IFs are also exchange-traded funds (ETFs).

Such funds are passively managed funds because they merely track the performance of a particular index. Passively managed funds do not require a fund manager to actively churn the portfolio, as the fund needs to simply hold the stocks in the same proportion as the index. Such a strategy translates into lower management costs. While actively-managed funds have an expense ratio of about 1-2% on regular plans, index funds come with an extremely low expense ratio of approximately 0.20% or lower. As a result, these funds are generally considered as ideal core portfolio holdings for retired people living off a fixed pension income.

However, simply knowing the definition is not enough. It is important to understand how this fund works.

HOW DOES IT WORK?

As we explained above, an index fund basically mirrors an index like the Nifty or Sensex. However, it differs from a typical equity fund in that a fund manager does not have any say at all when it comes to stock selection. The portfolio of IFs in India continues to mirror that of an index at any given time, with regards to both; the choice of stocks as well as the percentage holding. As a result of this correlation, the Net Asset Value or NAV of any given index fund, moves in tandem with that of the index it tracks.

Let us look at it with an example

Let’s say the Sensex index rises by 15% in a month, the NAV of an index fund based on the Sensex will also roughly rise by 15% over that same period. Conversely, should the Sensex drop by 12%, then the index fund NAV will also drop by the same 12%.

TYPES OF INDEX FUNDS

Such funds are broadly classified into three categories. These are:

  • Broad Market – These funds typically track bellwether indices such as Nifty or Sensex, which cover a large swathe of the market. These index funds invest in indexes designed to track the performance of the entire market or its subset, for instance, large-cap stocks (for example the Nifty 100).

  • Global – Also known as International Index funds, these are meant to provide investors exposure to stocks around the world (for example, stocks that make up the Nasdaq 100).

  • Sector-specific– These funds track a sector’s performance (for example, Nifty Bank).

OBJECTIVE

The key objective is to generate returns which are commensurate with the performance of the index it tracks, subject to errors associated with tracking. Generally, such funds allocate 95% funds into securities which are covered by the index, whereas the remaining 5% may be allocated to money market instruments or kept in cash.

If an investor has a long-term financial goal and is willing to stay invested for a longer duration, specifically in large cap-index stocks, he could potentially generate returns which are similar to that of the stock market. In such situations, the investor’s objectives may correspond to the fund’s objective.

TIPS FOR INVESTING IN INDEX FUNDS

If the idea of investing in IFs in India appeals to you, follow the tips below before making an investment:

  • If you wish to invest in such funds, choose the broad market ones. Such a fund covers a significant portion of the market. The Nifty Top 100 is one such example.

  • If you are new to the markets, then IFs are a good idea, to begin with. It will give you exposure to a broad-market portfolio, whereas you will be incurring low costs of fund management.

  • Some of these funds are also available as exchange-traded funds or ETFs. The main difference between ETFs and mutual funds is that the former is listed on the stock exchanges and traded like shares. This makes it easy to buy and sell stocks. You can trade ETFs through your demat-cum-trading account.

  • Look for funds with a low tracking error. Tracking error is essentially a measure of how accurately or inaccurately the fund tracks its index. Lower the tracking error, the more closely the fund mirrors the index.

Each stock has a different weight in the index. The portfolio of an index fund is also allocated in the same way. For example, if stock A has a weight of 10% in an index, a fund in the same index will also allocate 10% of the portfolio to the stock. These kinds of portfolios are ideal for people who do not wish to take the risk of leaving decisions to a fund manager.

REASONS TO INVEST

So, what are the advantages of an index fund?

Now that we have covered what is an index fund, let’s take a look at the reasons why you must invest in these funds:

  • Low costs: As we mentioned, IFs are passively managed and, as a result, come at a low cost because the fund house does not need an active fund manager. The expense ratio for such funds could be as low or lower than 0.2%. Actively managed funds typically have an expense ratio of around 1-2%.

  • They enable the investor to harness the stock market’s long-term potential, without going into detailed research or history of the stock’s performance.

  • Usually funds can be bought or sold according to the Net Asset Value or NAV at the end of the day. However, these funds are mostly exchange-traded funds and you can buy units any time during market hours.

  • Over the long term, broad market index funds mirror the overall performance of the stock market. In a growing economy, such a fund is a safe bet and likely to deliver reasonable returns at low cost.

Many believe that these funds will take their time to become popular in India. Since the returns from these funds are generally lower, investors tend to avoid such funds, without considering their other merits. But these funds can prove to be a good investment option for investors looking to minimise risks.

HOW IS AN INDEX FUND DIFFERENT FROM AN ACTIVE FUND?

The answer to the question is incomplete until we talk about how it differs from an active fund. Both funds are different in four aspects

  • Objective – Index funds aim to generate returns which correspond to the performance of the index that it tracks, whereas active funds attempt to outperform their own benchmarks as well as those of their peers.

  • Portfolio – Index funds hold the same stocks in similar proportions to those on the index, whereas those holding active funds may diversify across various stocks based on market caps and related factors, which may be outside the index.

  • Management – Index funds require little assistance from fund managers and can be managed passively, whereas fund managers regularly review the portfolio, conduct research and pick stocks in actively managed funds.

  • Cost – Since index funds are managed passively, the cost of managing this fund is very low as opposed to active funds which have higher management charges.

WHO SHOULD INVEST IN SUCH FUNDS

You must also check if such funds are a worthy investment for you before you decide to invest in them.

Index funds are an ideal investment tool for investors looking to participate in the wealth creation process in the long-term, especially if they want to participate in equity. Since these funds are passively managed and represent the broad market, they are also less volatile as compared to actively managed funds or diversified funds which are typically more aggressive in their style of investment.

Now that you know the tips, you can get started with investing in them at the earliest!

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