An index fund is a mutual fund that copies the composition of an index as its portfolio. Thereby, index funds try to track an index as it is.
A stock market index is a composition of shares representing the stock market or a sector as a whole. These shares are of top companies, and how they perform collectively often reflects how the stock market performs in general. For example, the Nifty is a stock market index that has the top 50 companies in India in its composition. How these 50 companies perform usually defines the sentiment of the stock market as well. An investor is banking in India’s overall development of the stock market when they invest in a fund that tracks the Nifty.
Similarly, there are indexes that track a particular sector, too These indices represent the sector’s sentiment. For example, the Nifty IT index tracks the performance of IT companies in India as a whole. There are index funds that track sector indices as well. The best index funds often follow the most popular indices. Let us learn more about index funds, the process of investing in them, and the risks associated with this article.
What is an Index Fund?
An index fund is a type of mutual fund that follows a specified set of rules to track a stock market index. A stock market index is a scale that helps investors measure the current price levels of the market. The index is derived by taking the share prices of the top companies in the stock market, a particular sector, or a subset of the market. An index fund basically follows the same composition as the index it follows.
For example, let us take the case of Nifty 50. Below is the current composition of Nifty 50 as of 16 Nov, 2022.
COMPANY | INDUSTRY | MARKET CAP.**(Rs m) |
| ADANI PORTS & SEZ | MISCELLANEOUS | 1,800,132 |
| ASIAN PAINTS | PAINTS | 2,957,207 |
| AXIS BANK | BANKING | 2,615,410 |
| BAJAJ FINANCE | FINANCE | 4,142,788 |
| BAJAJ FINSERV | FINANCE | 268,067 |
| BHARTI AIRTEL | TELECOM | 4,593,307 |
| BPCL | ENERGY | 664,768 |
| BRITANNIA | FOOD BEVERAGES | 997,676 |
| CIPLA | PHARMA | 905,206 |
| COAL INDIA | MINING | 1,449,782 |
| DIVIS LABORATORIES | PHARMA | 872,861 |
| DR. REDDYS LAB | PHARMA | 743,353 |
| EICHER MOTOR | AUTO | 957,765 |
| GRASIM | TEXTILES | 1,131,676 |
| HCL TECHNOLOGIES | SOFTWARE | 2,995,886 |
| HDFC | FIN. INSTITUTIONS | 4,860,529 |
| HDFC BANK | BANKING | 8,979,959 |
| HDFC LIFE INSURANCE | INSURANCE | 1,067,306 |
| HERO MOTOCORP | AUTO | 546,364 |
| HINDALCO | ALUMINIUM | 1,002,425 |
| HUL | FMCG | 5,826,900 |
| ICICI BANK | BANKING | 6,301,346 |
| INDUSIND BANK | BANKING | 865,371 |
| INFOSYS | SOFTWARE | 6,815,341 |
| IOC | OIL & GAS | 652,872 |
| ITC | FMCG | 4,239,112 |
| JSW STEEL | STEEL | 1,712,601 |
| KOTAK MAHINDRA BANK | BANKING | 3,893,423 |
| L&T | ENGINEERING | 2,815,535 |
| M&M | AUTO | 1,597,502 |
| MARUTI SUZUKI | AUTO | 2,757,764 |
| NESTLE | FOOD BEVERAGES | 1,938,920 |
| NTPC | POWER | 1,647,464 |
| ONGC | ENERGY | 1,798,351 |
| POWER GRID | POWER | 1,135,255 |
| RELIANCE IND. | ENERGY | 17,533,703 |
| SBI | BANKING | 5,345,842 |
| SBI LIFE INSURANCE | INSURANCE | 1,255,900 |
| SUN PHARMA | PHARMA | 2,442,523 |
| TATA CONSUMER | FOOD BEVERAGES | 709,595 |
| TATA MOTORS | AUTO | 1,331,348 |
| TATA STEEL | STEEL | 128,179 |
| TCS | SOFTWARE | 12,608,013 |
| TECH MAHINDRA | SOFTWARE | 1,029,435 |
| TITAN | CONSUMER DURABLES | 2,348,194 |
| ULTRATECH CEMENT | CEMENT | 1,994,481 |
| UPL | CHEMICALS | 586,787 |
| WIPRO | SOFTWARE | 2,275,848 |
| TOTAL | 137,140,070 |
An index fund that follows the Nifty 50 will have the exact same composition in most cases.
How does Index Fund work?
An index fund works similarly to any mutual fund, where there will be a fund manager who pools from different investors and invests in a portfolio that matches the theme of the fund. In the case of index funds, the portfolio is always similar to the index it follows.
The aim of an index fund is never to outperform an index but rather copy the performance the index has. For example, for an index has 10% growth in an annum, an index fund tries to replicate that. But often, the growth is slightly lesser. This is known as a tracking error. A tracking error can occur due to many factors, including expense ratio and other fees associated with investing in a mutual fund.
How to invest in Index Fund?
You can invest in investment funds just like you invest in mutual funds. First, you must figure out your investment goals and risk appetite. These two factors help with choosing the index fund. For instance, you may need to consider a fruitful fund in the short term if your goal is to create a corpus in one year. Risk appetite can help you understand the scale of risk that is acceptable to you. Once these two factors are figured out, you can either directly invest through a fund house’s website or indirectly through a broker’s website. A broker website makes the process easier for you but comes with a charge. After that, regardless of your choice, you will need to go through a KYC process and then fund the investment using any internet payment method except credit cards.
What are the risks of investing in an Index Fund?
Investing in index funds comes with market risks. Market risks are the risk associated with investing in any instrument dependent on the stock market. Below are some of the risk factors of investing in an index fund.
- Index funds directly invest in stocks; the same is the main component of the portfolio. Hence, index funds can be called equity funds as well. Equities are the most volatile yet potentially fruitful security. The same characteristics can be seen in the case of index funds as well. Hence, index funds are also at risk of volatility and sudden market price changes. Investing according to your risk appetite is important due to this reason.
- Index funds cannot outperform the index. However, if we look at five-, seven-, and ten-year periods and analyze recurring investments or SIPs, most funds outperform the index by a considerable margin. The potential to outperform the index by a considerable margin over a five- or ten-year period actually increases your wealth.
- An index fund won’t be able to profit from the stock market undervaluation. Fund managers can’t alter the allocation to a certain stock or sector since they have no influence over the portfolio’s makeup.
Index funds don’t have any hidden charges since they are heavily regularized, just like any other mutual fund. At the same time, one charge investors should be aware of is the expense ratio.
The expense ratio is the charge levied from investors in a fund for the upkeep of the fund. This includes compensation for the fund manager and profit for the fund house.
What is an index account?
An index account is another name for an index fund. They try to mimic the performance and portfolio of a particular index.
What are the best Index Funds to invest in?
The best index funds to invest in are usually the ones that follow the larger stock market indices. One example of the same in India is the Nifty index funds and Sensex index funds. They are the two larger indices in India and reflect the growth of the Indian stock market in general.
What makes Nifty and Sensex a good option is the growth they had in the past.
For example, as of Mid-September 2022, Nifty has grown over 75% in the last five years. That means you could have grown your corpus by 75% if you had invested in a nifty index five years ago.
Similarly, S&P 500 and Dow jones industrial average are the two best indices to follow if you are looking for options from the U.S.
Some of the best funds to invest in India includes IDFC Nifty 50, Nippon India Index Fund S&P BSE Sensex, and HDFC Index S&P BSE Sensex.
Some of the U.S index funds include Fidelity ZERO Large Cap Index, Vanguard S&P 500 ETF, and SPDR S&P 500 ETF Trust.
What is S&P 500 index fund?
An S&P 500 index fund is a mutual fund that tracks the performance of the S&P 500 index in the U.S. The S&P 500 index contains the top stocks that are trading in the U.S stock markets, and they reflect the sentiment and the growth of the U.S stock markets. The U.S is considered one of the fastest-growing stock markets and investing in an index fund that tracks top U.S stocks gets you an opportunity to take advantage of that growth. It is usually a small percentage of the corpus you have invested. Investors are advised to check this fund as a higher expense ratio could eat into your profits. In the last five years, the S&P 500 index has grown about 55% since mid-September 2022.
Is Index Funds the same as ETFs?
Index funds are not the same as ETFs. Exchange-traded funds work similarly to index funds, though. To begin with, ETFs are not mutual funds, but they also track an index as it is. Units of ETFs are also tradable in the stock market, unlike in the case of mutual funds.
What is the difference between Index funds and Index Stocks?
Index Funds are passive mutual funds that replicate the performance of famous market indexes. The Fund Manager does not actively choose sectors and companies for the fund’s portfolio; instead, he invests in all the stocks comprising the index to be tracked. The weighting of each stock in the fund roughly corresponds to its weighting in the index.
Index stocks are shares that represent the indices. They find their spot in the index in accordance with its weightage. For instance, the found may have a newly found higher market cap if the market cap is the weightage.
What is the difference between Index Fund and Mutual Fund?
Below are the top differences between an index fund and a mutual fund.
- An index fund is a type of mutual fund. A mutual fund is an investment vehicle where money is pooled from different investors to invest in a portfolio made of different securities like stocks, debts, commodities, currencies, etc. Here, the index fund’s portfolio will be the same as the composition of the index it tracks.
- Index funds are managed passively. It is not necessary for the fund manager to select equities. Mutual funds are managed actively. The fund manager makes the decision on which stocks and bonds to invest in.
- Index funds typically yield an average market return, whereas actively managed mutual funds seek alpha (return in excess of their benchmark return) by making active stock selection decisions for their portfolio. The higher predicted return comes at the expense of increased risk when compared to Index Funds, which simply track an index and generate returns.
