What are index funds?

Index funds are a type of mutual fund that invests in a market index like Nifty or the Sensex. These funds purchase all the stocks in the same proportion as in a particular index. It seeks to replicate the performance of an index. This means the scheme will perform in tandem with the index it is tracking, save for a small difference known as tracking error.

How do they work?

When an index fund tracks a benchmark like the Nifty, its portfolio will have the 50 stocks that comprise Nifty, in the exact same proportions. An index is a group of securities defining a market segment. These securities can be bonds or stocks.

Since index funds track a particular index, they fall under passive fund management. In this, the fund manager decides which stocks have to be bought and sold according to the composition of the underlying benchmark. Unlike actively-managed funds, there isn’t a standalone team of research analysts to identify opportunities and select stocks.

Index funds typically deliver returns more or less equal to the benchmark. However, sometimes there can be a small difference between the fund performance and the index. It’s known as the tracking error. The fund manager will try to reduce the tracking error as much as possible.

Who should invest in index funds?

Index funds are ideal for investors who are risk-averse and want predictable returns. These funds give you predictable returns matching the upside that the particular index sees.

Advantages

Low Expense Ratio:

Index funds have a low expense ratio, of about 0.5% as opposed to actively-managed funds which have an expense ratio of about 1% to 2.5%.

No fund manager error:

Index funds simply track an index. They only have ‘tracking error’, but this is of a much lower magnitude than fund manager error.

Efficient Market Hypothesis:

No fund manager or investor can outperform the market in the long run. Price anomalies are eventually discovered by competitors and stocks are priced according to their fundamental value. Hence an index fund that represents the market will outperform all active funds in the long run.

Disadvantages

No beating the market:

An investor buying into this type of fund gives up the chance of beating the market by picking a good actively managed fund.

Mature companies:

Index companies tend to be mature companies who have their best growth years behind them. Investors in such funds do not benefit from the growth potential of small companies.

Expensive Valuations:

Companies in the index have been discovered by the market. In other words, investors are buying stocks that are already expensive.

Explore our list of Index Funds here.

DISCLAIMER

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.



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