What are Index Funds & How to invest in index funds

13 Nov 2021|

6 min read |

by ICICI Securities Team

Imagine a basket of some of the most famous fruits available—like apples, oranges, and bananas. Their prices change with their going market rate. An index fund works on the same model. But instead of fruit, it contains a lot of stocks—essentially investments in companies. Those stocks are chosen so as to track a certain market index, which is essentially just a fancy word for a list of companies considered super important. By putting your money into an index fund, you are, in essence, buying a tiny piece of all those companies and hoping the value will rise a few years down the line!

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What Are Index Funds | How To Invest In Index Funds | ICICI Direct

What are Index Funds?

Index funds are a form of an exchange-traded fund or mutual funds with a stock portfolio that attempt to emulate the performance of a particular index it uses as the benchmark.
Index funds are a form of passive fund management built around a portfolio that mimics the securities of a particular index, with the idea of emulating the performance of the said index.
Index funds only change their portfolios if the index itself has gone through a significant change or to balance the fund in case the fund follows a weighted index.

Additional Read: 7 reasons to invest in Mutual Funds

How do Index Funds Work?

Index fund management means investing in a portfolio of stocks or bonds that imitates a specific market index. For instance, an index fund aligned to Nifty 50 would hold shares of the fifty companies aligned proportionately in the Nifty 50 index. Here, the role of the fund manager is to replicate the performance of the index as closely as possible. With their nature to mimic the market rather than outperform it, index funds can, and often do, have much fewer fees compared to actively managed funds. The broad market exposure and diversification underpinned by an underlying index works in support of the strategy.

Example of an Index Fund

An example of such an index fund is the Nifty 50 Index Fund. This is an Investment Fund whose objective is to replicate returns of the Nifty 50 index. The latter constitutes the 50 largest and most liquid companies listed on the National Stock Exchange of India. Therefore, any investments made in this index fund result in an investor owning a small portion of each of these 50 companies, thereby gaining exposure to a large sector of Indian markets. Its value goes up or down with the Nifty 50, and the investment process under it is simple in the performance of the market.

Types of Index Funds

Index funds can be classified into the following subtypes:

General market index funds emulate a significant portion of the stock market and are generally the least expense intensive and the most tax-efficient.
Market capitalisation index funds structure their portfolios according to the market shares held by the companies in the portfolio.
International index funds mimic the performance of global indexes.
Earnings based index funds are based on the profits generated by companies.
Bond based index funds invest and mimic the performance of different types of bonds.

Advantages and Disadvantages of Index Funds

Advantages of Index Funds are as follows:

Index funds work on the principle of passive management resulting in a low expense ratio in management costs.
Index funds work by matching the performance of an index, which can lead to better long term returns due to their focus only on stable growth and not high-risk speculation.
Index funds are ideal for passive investors simply looking to buy and hold stocks for the long term.
Since an index fund attempts to mimic the performance of an index, it buys stocks from a broad segment of the economy, allowing for easy and high diversification.

Disadvantages of Index Funds are as follows:

Since an index fund follows an index closely and attempts to mimic its performance, index funds are vulnerable to market fluctuations and crashes.
Index funds lack flexibility, as investors can choose only that which enables the fund to mimic the index's performance.
Index funds require very little human oversight and are thus vulnerable to cyber attacks.
Index Funds have low returns, which are only feasible during a bull market or with a long-term investment plan.

Who should invest in an index fund?

New investors: This is a very painless way to get into the stock market without having to worry about picking any particular stock.

Long-term investor: Index funds are for steady growth over time—perfect for retirement savings or long-term goals.

Cost-conscious investors: Mostly, index funds charge lower fees compared to actively managed funds.

Risk-averse investors: Broad diversification lowers risk as compared to single stocks.

How to invest in index fund?

Open a brokerage account: This is kind of like your online window to buy and sell investments. Check out different brokers and find one with low fees, that has a clean user interface.

Pick an index fund: Consider your goals, and your risk tolerance. Broad market funds track the entire stock market, while sector funds are pegged to a particular industry.

Invest! You can buy shares of the chosen index fund directly through your brokerage account.

Long-term approach: The index fund is for long-term, steady growth, so one must be prepared to stay invested for several years, till the cycles of the market sort themselves out.

Automate: Setup an SIP to invest a fixed amount at regular intervals. This often is one of the best ways to build wealth gradually.

Benefits of Investing in Index Funds

Low Cost: Index funds charge less for fees than actively managed funds, so more of your money grows for you.

Diversification: Your risks are reduced by spreading the bets among many companies, contrasted with choosing only some individual stocks.

Passive Investment: No constant research needed in picking stocks. Index funds track the market, so you can sit back and watch.

Long-term growth: Index funds strive to be representative of the market as a whole, and the market has risen over time.

Factors to Consider Before Investing in Index Funds in India

Investment Horizon: Index funds shine long-term (7+ years). Short-term goals might be better suited for other options.
Expense Ratio: Compare fees between index funds. Lower expense ratios mean more money stays in your pocket.
Tracking Error: See how closely the fund tracks its index. A lower tracking error means better performance.
Taxation: Understand how capital gains tax applies to your investment strategy.
Your Risk Tolerance: Index funds spread risk, but they aren't risk-free. Consider your overall portfolio balance.

List of Best Index Funds

S. No	Index Fund Name	Tracking Index	Expense Ratio (%)	10-Year Avg. Annual Return (%)
1	Nifty 50 Index Fund	Nifty 50	0.17	16.73
2	Sensex Index Fund	BSE Sensex	0.18	16.16
3	Nifty Next 50 Index Fund	Nifty Next 50	0.30	24.35
4	Nifty 500 Index Fund	Nifty 500	0.20	19.99

What is the Cost associated with index fund

Expense Ratio: This is an annual charge for the management of the fund and other expenditures involved. Index funds mostly come with a lower expense ratio compared to their actively managed counterparts.

Trading costs: There are minimal costs associated with index funds when buying or selling securities to replicate an index. Such costs generally are insignificant as compared to the expense ratios.

Taxes: Think about the capital gains on your profit from selling shares of your index fund. It is applicable when you sell the investment for more than the price you bought it for.

Risk associated with index fund

Market Risk: Index funds reflect the overall market performance. If the market dips, so will your fund's value.

Tracking Error: Though small, index funds might slightly underperform the target index due to factors like expense ratios and sampling techniques.

Limited Upside: Unlike actively managed funds, index funds can't outperform the market. You won't see explosive growth, but also less chance of significant losses.

No Control: The fund manager picks holdings based on the index, so you can't influence specific companies within the fund.

Conclusion

Index funds are an attractive form of investment due to their inherent low risk and relative stability. However, their low returns and vulnerability to market crashes can make them a risky proposition. Investors would be more secure investing in managed funds for short term gains, with investments in index funds better suited to long term financial requirements. Mixing investments would allow investors to circumvent the disadvantages of index funds.

Index Funds FAQs

Is an index fund good or bad?

Index funds are a good fit for long-term investors seeking low-cost diversification. They offer steady growth but may not outperform the market. Consider your goals and risk tolerance before investing.

Compare index funds vs mutual funds.

Index funds passively match a market index, offering lower fees and mirroring market returns. Mutual funds are actively managed, aiming to beat the market but often come with higher costs and potentially lower returns.

Are index funds 100% safe?

No, index funds aren't 100% safe. While diversified, they're still subject to market fluctuations. They can lose value, but historically, they've grown over time.

Which index fund has the highest return?

Predicting top performers is tough, though NIFTY 50 Index Funds has performed well. Past returns don't guarantee future success. Focus on overall asset allocation and choosing an index fund that aligns with your goals.

What is the lock-in period for index funds?

Index funds in India typically don't have lock-in periods. You can freely buy and sell units anytime!

How Many Index Funds Should You Own?

The ideal number of index funds depends on your investment goals. 3-5 funds can offer good diversification, but consult a financial advisor for personalized advice.

Is It a Good Time to Invest in Index Funds?

Index funds are for long-term investing. Trying to time the market is difficult. Regularly investing, even in downturns, can benefit from long-term growth!

Are Index Funds Better Than Stocks?

It depends! Index funds offer diversification and lower fees, but steady growth. Stocks can potentially offer higher returns, but with greater risk. Consider your goals and risk tolerance.

Disclaimer