All About Index Funds Explained Here
An “index fund” is a type of mutual fund or exchange-traded fund
that seeks to track the returns of a market index. The S&P 500
Index, the Russell 2000 Index, and the Wilshire 5000 Total Market Index
are just a few examples of market indexes that index funds may seek to
track.
A market index measures the performance of a “basket” of securities
(like stocks or bonds), which is meant to represent a sector of a stock
market, or of an economy. You cannot invest directly in a market index,
but because index funds track a market index they provide an indirect
investment option.
What is in an index fund?
Index funds may take different approaches to track a market index:
some invest in all of the securities included in a market index, while
others invest in only a sample of the securities included in a market
index.
Market indexes often use a company’s market capitalization
to decide how much weight that security will have in the index. Market
capitalization (or “market cap”) is a measure of the total value of the
company’s shares. The total value is equal to the share price times the
number of shares outstanding. In a market-cap-weighted index, securities
with a higher market capitalization value account for a greater share
of the overall value of the index. Some market indexes, such as the Dow
Jones Industrial Average, are “price-weighted.” In this case, the price
per share will determine the weight of security.
Some index funds may also use derivatives (like options or futures) to help achieve their investment objective.
How do index funds invest?
Index funds have generally followed a passive, rather than active, style
of investing. This means they aim to maximize returns over the long run
by not buying and selling securities very often. In contrast, an
actively managed fund often seeks to outperform a market (usually
measured by some kind of index) by doing more frequent purchases and
sales.
What are the costs associated with index funds?
Because index funds generally use a passive investing strategy, they may
be able to save costs. For example, managers of an index fund are not
actively picking securities, so they do not need the services of
research analysts and others that help pick securities. This reduction
in the cost of fund management could mean lower overall costs to
shareholders. However, keep in
mind that not all index funds have lower costs than actively managed
funds. Always be sure you understand the actual cost of any fund before
investing.
Fees and expenses reduce the value of your investment return. If the
holdings of two funds have identical performance, the fund with the
lower cost generally will generate higher returns for you. For more
information, see our Updated Investor Bulletin: How Fees and Expenses Affect Your Investment Portfolio.
What are some risks of index funds?
Like any investment, index funds involve risk. An index fund will be
subject to the same general risks as the securities in the index it
tracks. The fund may also be subject to certain other risks, such as:
- Lack of Flexibility. An index fund may have less flexibility than a non-index fund to react to price declines in the securities in the index.
- Tracking Error. An index fund may not perfectly track its index. For example, a fund may only invest in a sampling of the securities in the market index, in which case the fund’s performance may be less likely to match the index.
- Underperformance. An index fund may underperform its index because of fees and expenses, trading costs, and tracking error.
Best Index Funds in India: Invest in Top Index Funds of 2021
Index mutual funds are a class of equity 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 their underlying
index.
Why Should You Invest in Index Funds?
Index funds are considered one of the most secure equity funds as their
portfolio consists of blue-chip stocks. These are the stocks of
well-established companies with an excellent track record. This makes
index funds less susceptible to market fluctuations and thereby offering
much-needed stability.
Indian benchmark indices NSE Nifty
50 and S&P BSE Sensex have performed overwhelmingly over the past
three decades. They have fought several challenges such as the recession
in 2008, the outbreak of several viruses (Zika, Ebola, SARS, H1N1, and
so on), geopolitical tensions (such as the Sino-American trade war) and so
on. Despite such difficulties, the indices have gained significantly
since their inception.
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.
Best Index Funds in India
The following table shows the best index funds in India, based on the past 10-year returns: As of OCT 22 2021
Before You Invest
Before investing in any fund, you should carefully read all of the fund’s available information. This includes the fund’s prospectus and most recent shareholder report. In addition, funds disclose their portfolio holdings quarterly in Form N-Q and shareholder reports. You can typically get this information from the fund’s website or your financial professional, as well as on EDGAR.
Asking the following questions might help:
- What fees and expenses can I expect to pay for buying, owning, and selling this fund?
- What specific risks are associated with this fund?
- How is the makeup of the fund’s index determined?
- How does the fund’s investment strategy fit with my investment goals?
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