The functioning and nature of index funds explained

Index funds are a type of mutual fund that tracks a specific market index, such as the Nifty 50 or Sensex. This means that they invest in the same stocks as the index, in the same proportions. This makes them a low-cost, diversified way to invest in the stock market.

The article will discuss the benefits of index funds, and how they work. It will also provide some tips on how to choose the right index fund for your investment goals.

What are index funds?

Index funds are mutual funds that aim to mirror the performance of a market index, like Nifty 50 or Sensex, by investing in the underlying basket of securities in the index. Index funds are passively managed and seek to match the returns of the overall market, rather than outperform.

How do index funds work?

Index funds work by purchasing all or a representative sample of the securities in a particular index in the same proportions as the index. For example, an index fund tracking the Nifty 50 will invest in the 50 large-cap stocks in the Nifty 50 in proportions matching their index weightage. As the underlying securities move up and down in price, the index fund mirrors these movements.

Benefits of index funds

Index funds have several advantages that make them a popular investment in India:

Low Costs: Index funds do not require active stock picking and are cheaper to manage than actively managed mutual funds, with lower expense ratios. This cost advantage enhances net returns.

Diversification: Index funds provide instant diversification as they track the overall broader market or sector rather than individual stocks. This reduces portfolio risk.

Transparency: Index funds transparently track published, rules-based indices. Investors know the portfolio allocation and returns are in sync with the index.

Consistent Returns: Index funds are designed to earn returns equivalent to the overall market rather than chase alpha. This provides stability during volatile markets.

Ease of Investment: Index funds allow retail investors easy access to the performance of the stock market by purchasing a single fund. Regular investing in index funds is an easy way to grow wealth.

Index funds vs active funds

Index funds and active mutual funds differ in their approaches to investing, leading to variances in their returns. Index funds simply aim to match market returns at low cost while active funds attempt to beat the market through stock selection, but charge higher fees. Over long periods, the majority of active funds fail to exceed index returns after accounting for their fees. According to SPIVA data, over 10 years 80% of active Indian equity funds underperform benchmarks. However, some active funds can outperform during short-term volatility when managers capitalize on mispricings. But such outperformance is inconsistent, while index funds reliably capture market returns. The lower expenses and tax efficiency of index funds enhances their net returns versus active funds over the long run. In summary, index funds provide market-matching returns more dependably and cheaply than most active funds over the long term. But skilled active managers can add value at times, so blending both passive and active approaches allows investors to gain the advantages of each strategy.

Index mutual funds and ETFs provide a low-cost, diversified way for retail investors across India to invest in the stock market. With transparency, ease of access and consistent market-linked returns, index funds are an ideal passive investing vehicle suitable for core portfolio holdings.