7 things you must know about index fund

Padmaja Choudhury   /   August 28, 2023

Are you becoming more interested in investing in index funds and fulfilling your goals? As of July 31, 2023, the total Assets Under Management (AUM) under index funds stood at Rs.1.8 lakh crore in India up from Rs. 94,589.50 crore in July 31, 2022 i.e. almost 90% up in one year.

So, why are investors getting hooked on index funds? Let’s find out.

  1. Ease of understanding

Picking the right mutual fund is crucial for achieving investment returns. However, everyone only has a little time and know-how of the funds to select the right fund. Here comes index funds, which mirror specific market indices and invest in the same underlying assets as the market index and in the same proportion. This helps the investors easily acquire knowledge of the underlying assets and helps in tracking the fund’s performance by comparing it with the market index itself.

  1. Lesser expenses

The fund managers of index funds do not have to pick the underlying securities, such as stocks or bonds, for the fund, nor do they have to reallocate the assets from time to time. Due to this reason, the expense ratio of index funds is lower than actively managed funds, where the fund manager has all the responsibilities and rights to choose the underlying assets and change them according to market conditions.

  1. Correlated returns

Since the index funds replicate the market index it follows, the returns of the fund are positively correlated with the movement of the index. For instance, suppose an index fund mirrors the Nifty 50, and the index rose by 10% in the month. Look at the Nifty 50-linked index fund. You will find that the price of one unit of the mutual fund, i.e., Net Asset Value (NAV) of the fund, had also increased by around 10% in the same period. This makes tracking the performance of the funds easier for investors.

  1. No fund manager’s bias

Fund managers decide the underlying assets of any mutual fund except for index funds. Here, the fund manager must maintain the exact ratio of each underlying security as per the benchmark index. For instance, if an index fund is linked to the Nifty 50, then the fund manager has to invest in the same fifty stocks that are in the Nifty 50 index. Moreover, the ratio of each stock has to be the same in the fund as in the index. This leads to no fund manager’s bias, which helps investors get returns similar to the index.

  1. Index funds’ investment strategy

Most of the mutual funds try to outperform the benchmark index they track. However, the index funds investment strategy is not to beat the benchmark but rather to replicate it. This makes the index funds suitable for investors looking for returns similar to the index.

  1. Tracking error

Every mutual fund has a benchmark index that is used to measure the fund’s performance. In actively managed funds, the fund manager aims to beat the returns the benchmark indices offer.

However, the index fund aims to match the benchmark’s returns. The difference between the fund’s and benchmark’s returns is called the tracking error. We can say that the index fund with a low tracking error has done better at replicating the underlying index than an index fund with a higher tracking error.

  1. Different types of index funds

Index funds can be categorised based on the type of the underlying benchmark index. There are:

Broad market index funds are linked to broader indices such as Nifty 50 and S&P 500.

Market capitalisation index funds are linked to indices comprised of companies’ stocks falling under certain market capitalisation.

Smart Beta Index Funds are linked to indices that follow certain factors or investment strategies. There are also thematic index funds linked to indices with specific investment themes and strategies.

Sector-based index funds are linked to indices with stocks of any particular sector, for instance, Nifty IT or Nifty Bank.

Debt Index Funds are linked to bond indices or any other fixed-income indices.

Commodity Index funds are linked to indices having commodities in them, such as the Gold Index.

Wrapping up

Index funds have emerged as a powerful tool for achieving financial goals. Their simplicity, low expenses, and ability to deliver correlated returns with benchmark indices make them popular among investors.

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