An index fund is a mutual fund that imitates the portfolio of an index. These funds are also known as index-tied or index-tracked mutual funds. These funds are passively managed as the main objective of index funds is to track and emulate the performance of a popular stock market index such as S&P BSE Sensex and NSE Nifty 50. The asset allocation of an index fund would be the same as that of its underlying index. It is for this reason that the returns offered by index funds are comparable with its underlying index.
How do Index Funds Work?
When an index fund tracks a benchmark like the Nifty, its portfolio will have the 50 stocks that comprise Nifty, in the same proportions. An index is a group of securities defining a market segment. These securities can be bond market instruments or equity-oriented instruments like stocks. Some of the most popular indices in India are BSE Sensex and NSE Nifty. Since index funds track a particular index, they fall under passive fund management. 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 as index funds track an index.
While an actively managed fund strives to beat its benchmark, an index fund’s role is to match its performance to that of its index. Index funds typically deliver returns more or less equal to the benchmark. However, there can be a small difference between fund performance and the index. This is referred to as the tracking error. The fund manager must work towards bringing down the tracking error as much as possible.
Advantages of Index Funds
Index funds come with a comparatively lower expense ratio as they are passively managed, and the asset allocation would more or less remain the same for an extended period. The asset allocation of an index fund would change only when there is a change in the asset allocation of its underlying asset. Therefore, the fund manager would not trade securities now and then, thereby keeping the expense ratio on the lower side.
The stocks constituting an index fund are generally of well-established companies, and they are not affected much by the market fluctuations. This means the returns provided by the index funds are consistent, and the possibility of losing the entire investment is almost negligible. Index funds are apt for those investors that are ready to bear some risk in exchange for restricted returns.
