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What is an Index Fund and How Does It Work?

Posted on 03-Jun-2024

6 min read

Wondering what is an index fund and how it functions? This article by Shriram AMC provides answers to all your queries to help you make informed investment decisions.

Table of Content

You are probably aware of all the types of funds and styles of investment in the world of mutual funds. But for the uninitiated, investors predominantly concern themselves with two kinds of investments —active and passive.

Active investing is when you give your money to a fund manager, who then decides which stocks to buy and which ones to sell, maximizing your returns. Passive investing does not involve a fund manager at all. Its main purpose is to replicate the returns of the index (think NIFTY 50 and SENSEX!). This is the underlying principle on which index funds work.

Index funds are passive funds (not to be confused with passive investing) that give you exposure to the indices. Now, get a snack, sit tight, and join us while we decode more about what an index fund is and how it works!

What are Index Funds?

Index funds are like investment vehicles that mirror the performance of a stock market index, such as the NSE NIFTY, BSE Sensex, etc. Instead of a manager actively picking stocks, the fund buys all (or a sample) of the stocks in the index.

Think of it like buying a basket of groceries that contains everything on a shopping list. These passively managed funds offer lower costs and aim to match the market's return. They suit long-term investors seeking diversification and stable growth, aligned with a 7+ year investment horizon.

How Do Index Funds Work?

Before we dig deeper into the mechanism of index funds, we need to clear up the air regarding the role of a fund manager right off the bat. Index funds are passive funds that are passively managed. However, unlike the passive style of investing, they do involve a fund manager.

Fund managers invest in the same securities as the chosen index and in the same proportion. And they do so without changing the composition of the portfolio. As a result, these funds mimic the stock market index to offer similar returns.

Let us now get into the specifics of how index mutual funds in India work with this simple breakdown:
  • Tracking an Index: Each index fund chooses a specific market index to follow. Examples include Nifty 50, Nifty Next 50, or sectoral indices like Nifty Pharma.
  • Portfolio Construction: The fund manager replicates the index by investing in all the constituent stocks in the same weightage as they hold in the index.
  • Passive Management: Unlike actively managed funds with high turnover, index funds trade infrequently, keeping costs low. Rebalancing only occurs when the weightage of a stock changes significantly in the index.

What Are the Benefits of Index Funds?

Besides the broad exposure to the market and the elimination of active stock selection, index funds come with a plethora of advantages, making them a popular choice among investors. Let’s look at some of these perks of investing in index funds in this section:
  • Low Cost: Passive management translates to lower expense ratios compared to actively managed funds as the latter has a higher fee for professional management. This translates to higher returns for you.
  • Diversification: By holding a basket of stocks, index funds spread your investment across stock index funds and bond index funds. Furthermore, you have access to specialized index funds associated with specific markets.
  • Market Returns: Index funds aim to match the market performance, offering a good benchmark for your overall portfolio.
  • Transparency: The holdings of an index fund are readily available, allowing for clear investment visibility.
  • Tax Efficiency: Index mutual funds offer several tax benefits like lesser long-term capital gain taxes compared to other funds, as you do not trade these funds actively.
  • Ideal for Beginners: Since index funds do not require active management or a vast knowledge about the market, they are ideal for anyone with enough money to start investing.

What Are the Limitations of Index Funds?

Index funds come with certain risks and limitations, just like every other mutual fund. And any investor worth their salt must know about the pros and cons of these funds.

On that note, let’s take a look at the drawbacks of investing in index funds in India:
 
  • Market Reliance: Index funds are tied to the performance of the tracked index. If the market dips, so does the fund's value.
  • Limited Outperformance: Index funds are unlikely to outperform the market significantly. They aim to match, not beat, the benchmark.
  • Less Control: Investors have less control over individual stock selection within the fund.
  • Fluctuations in the Short Term: Index funds are better suited for investors with a long-term horizon as they can experience short-term fluctuations negating investment gains.
     
In a nutshell, index funds typically share the same risks as stocks and securities in the index it mimics.

Are Index Funds Better than Stocks?

Index funds and stocks each have their own strengths and weaknesses, making them ideal for different investment strategies. From all we have discussed so far, it’s clear that index funds are great for beginners with no investment or financial expertise. However, the same cannot be argued for stocks.

Only if you're comfortable with higher risk for the potential of higher returns and enjoy researching companies, then stock picking might be a good fit. Plus, investing in stocks also requires high financial acumen and knowledge about the share market. Therefore, stocks are not meant for beginners.

Therefore, the “better” option for you depends upon your risk appetite, financial goals and knowledge about investments.

Are Index Funds Good for Beginners?

Index funds are a wise choice for a broad range of investors owing to their simplicity and diversification. But if you needed more reasons to start investing in these funds, here are some:
  • Index funds are cost-effective as they are not actively managed, thus eliminating the aspect of a high expense ratio.
  • Index funds are easy to invest in as they do not require active fund selection or any complicated understanding of mutual funds or the share market.
  • As a beginner, you may want a passive, hands-off approach to managing mutual funds. And there cannot be anything better than index funds to serve this purpose.

Factors to Consider Before Investing in Index Funds in India

Although index funds are less risky than many other types of mutual funds and are simple to manage, there are several things to factor in before you begin your investment journey:
  • Investment Horizon: Index funds are well-suited for long-term goals due to their market-linked nature.
  • Risk Tolerance: Index funds carry market risk, so assess your comfort level with potential fluctuations.
  • Fund Expense Ratio: Compare expense ratios of different index funds to choose the most cost-effective option.
  • Tax Implications: Understand the tax implications of investing in index funds in India, including capital gains tax.
  • Fund House’s Reputation: It is important you choose index funds from asset management companies that are reputable and offer an investor-friendly approach. Shriram AMC can be your trusted partner in this journey, offering you sound financial advice and helping you make fruitful investment decisions.

Wrapping Up

This elaborate discussion on index funds in India shines a light on a few important factors. First, index funds are passive funds that imitate the returns of the chosen index. Second, they are cost-effective, with a low expense ratio (due to the lack of active management), and a great start to exploring the mutual funds market for beginners. Finally, though there are inherent risks associated with these funds, index funds are generally considered safe.

By understanding these aspects, you can make informed decisions about incorporating index funds into your investment strategy for the Indian market. Remember, consulting a financial advisor or a reputable fund house like Shriram AMC, can provide personalized guidance based on your specific financial goals.
 

FAQs

Here are a few frequently asked questions about index funds in India:
 
1. Are there different types of index funds in India?
 
Yes! India offers a variety of index funds tracking various market indices like Nifty 50, Nifty Next 50, sectoral indices (Nifty Pharma, Nifty IT), and even thematic indices.
 
2. How do expense ratios impact my returns in index funds?
 
Expense ratios are a yearly fee deducted from the fund's assets. Lower expense ratios mean more money stays invested and contributes to your returns. Compare expense ratios of different index funds to pick the most cost-effective option.
 
3. What happens to my index fund if a stock in the index is delisted?
 
The fund manager will sell the delisted stock and reinvest the proceeds in the new stock that replaces it within the index, ensuring your fund continues to track the index accurately.
 
4. Can I invest in index funds directly or through a mutual fund platform?
 
In India, index funds function as exchange-traded funds (ETFs) or mutual funds. You can invest directly through a brokerage account for ETFs or through mutual fund platforms for both ETFs and index mutual funds.
 
5.How do taxes work with index funds in India?
 
Capital gains tax implications depend on how long you hold the index fund (equity or debt orientation) and the type of holding (direct or regular plan). Consult a tax advisor for specific details based on your situation.
 

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