What is an Index Fund?
An index fund is a passive fund which replicates indices like BSE Sensex, Nifty 50 etc. Their performance is entirely based on indices they are replicating. E.g. Nifty comprises of 50 stocks from different sectors in different weightages. Nifty Index Fund will invest the money in the stocks present in the Nifty 50 according to their weightages. If Nifty gives 12% returns, then Nifty index fund will give nearly 12% returns.
Before we proceed to understand an index fund, let us understand what an index is.
Understanding an Index
An index is a tool that tracks and measures the value of anything, starting from a reference point. Suppose there is no such index. How will you measure the performance of the stock market? Secondly, how will you select in which stock, in which industry, in which sector you have to put money. Thirdly, how will you know how they perform, the stocks and mutual funds you already hold? Whether they are performing good or bad etc.
Therefore, Index is anything which tracks, measures, and benchmark something. i.e. it is tracking a sector, measuring its performances, and being used as a benchmark by various investors and financial institutions. As the Index is tracking something, there are some underlying constituents to it that form the Index. E.g. Sensex 30 has 30 companies in it, and Nifty 50 has 50 companies that track and measure India’s economic status.
Actively Managed Funds vs Passively Managed Funds
In actively managed funds, a fund manager is there, with the ability, skill and knowledge to pick the stocks based on his research and analysis and give you much higher returns in what the Index is giving. For this, you pay him a high expense ratio for managing your money.
In passively managed funds, a fund manager is also there, but he does not utilise his skill and ability to pick the stocks. He will invest your money according to its weightage in the stocks that are in an index. Index funds track the performance of the indices. It will give the same returns as given by the indices. Hence, its expense ratio is very less. These funds are gaining popularity and becoming more and more stronger with time due to its low expense ratio, less expertise required in selecting the funds and consistently outperforming the actively managed funds in the long run.
Benefits of Index funds
- Index funds give diversification to your portfolio as they invest in all the stocks that are part of the Index.
- These are the low-cost funds that have the capability of outperforming mostly the actively managed funds.
- Index funds are less risky equity funds.
- The fund manager has no direct role in these funds. They invest the money in the stocks that are part of the Index according to their weightages. Hence, its expense ratio is low.
How to invest in an Index?
There are three ways to invest in an index.
- Directly buy all the stocks of the companies that are part of Index exactly in the same proportion.
- Buying an index mutual fund.
- Through ETFs (Exchange Traded Funds).
When you directly buy all the stocks from the stock exchange, you need a lot of capital or initial investment. Hence, the second and third methods are considered the best way to invest in an index.
Difference between Index Mutual Funds and ETFs
- You can buy an index fund from the Asset Management Company or Fund house, but you can buy an ETF from the stock exchange only as they are traded like a stock.
- You need a Demat and a trading account to buy and sell ETF which is not required in case of index mutual funds.
- Index mutual funds are very limited, i.e. Nifty and Sensex. But various options are available in ETF besides Nifty and Sensex like Bank Nifty, Junior Nifty etc.
Conclusion
Index funds are quite popular in the US and other developed countries. But it has not yet become so famous in India. Indian economy is growing, and it will continue to grow in the future. It is likely to be a 10 trillion-dollar economy in the next 10 to 12 years. And if it is going to go from a 3 trillion-dollar economy to a 10 trillion-dollar economy, then the markets will do well. When the markets are going to do well, we’re talking about the Index. So, investing in the index funds should be a better bet in generating returns in the long term.
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