How do Index Funds Work

The world of investment can be overwhelming with countless different options available. Sometimes that can be enough to drive away someone from taking the first step. But even then, there are extremely simple methods to kick start your investment journey and make the most out of your hard-earned money. Index funds are one of the easiest ways to get started. 

Here’s everything you need to know about what index funds are and how they work.

What is an index fund?

Index funds are a special kind of fund that contains a portfolio of stocks or bonds that mirrors the performance of a financial market index. In other words, they simply replicate how the index and the market perform. Nifty Midcap 150, Nifty 200 Momentum 30, and Nifty Smallcap 250 are some of the indexes that these funds track.

Index funds are a perfect example of passive investing. Unlike active investing, where a fund manager is actively involved in the management of a mutual fund, index funds are not actively monitored by a fund manager. Since they match the performance of an index, their only goal is to focus on delivering stable returns to the investors without the element of speculation. Index funds have a relatively low expense ratio compared to traditional mutual fund investment options.

Index funds also allow easy and better diversification as they are built around a portfolio of assets. There are various categories of index funds:

  • General market index funds: These funds mimic a majority of the stock market. They are more tax-efficient and relatively less expensive compared to other index funds.  
  • Market capitalisation index funds: The portfolios of these funds are structured based on the market shares held by the portfolio companies. These are also known as market value-weighted index funds. A chunk of the fund is linked to the large-cap companies, making it a great option for those investors who have a longer investment horizon and want to get higher returns. However, financial experts caution against over-investing in these funds as they can comprise the diversification of your portfolio.
  • International index funds: These funds emulate how global indices perform. These funds are an excellent option for those investors who want to diversify their investments in the global market. 
  • Earnings-based index funds: Funds that track the profits generated by the companies fall within this category.
  • Bond-based index funds: Similar to stock-linked indices, these funds mimic the performance of different kinds of bonds issued in the market. These funds are great for investors who want diversification and also enjoy a steady stream of returns on monthly returns. 

How does an index fund work?

When you invest in an index fund, the money is directed towards the companies that are included in the particular index. This is how you get a diverse investment portfolio compared to what you would have had if you were buying individual stocks.

For example, if an index fund is tracking Nifty 150, there will be a total of 150 stocks in the portfolio, where each of them will carry a specified weightage based on the proportion of the index. How this index fund performs will depend on the actual performance of these stocks in the market. 

The tracking error of an index fund is a factor to consider. It indicates how closely will the fund mimic the returns of the benchmark index. The minimal the tracking error, the higher the expense ratio. On the other hand, a significant tracking error could indicate the fund is not managed very efficiently.

Unlike traditional mutual funds, where the fund manager is responsible for selecting the stocks to invest in, matching them with the movements in the market, and deciding what to buy or sell, a fund manager responsible for index funds strategizes how to build the right portfolio to mimic the securities of an index. In other words, they monitor the index which is being tracked and take a decision to buy or sell the underlying securities to match the index. So if you have the same portfolio that mimics the profile of the index, their performances will match up. 

As a passively managed fund, the goal of index funds is not to outperform the forces of the market. Instead, the focus is on matching the performance of the market. If the market performs well, the index your fund is linked to performs well and generates returns. 

Index funds can be sometimes structured as exchange-traded funds. These are known as index ETFs. Index ETFs consist of portfolios that are managed by professional fund managers or financial firms. The portfolio consists of a variety of securities such as shares, money market instruments, and shares. Similar to stocks, ETFs can be traded on the exchange. 

Are index funds good investments?

As always, jumping straight away into investing in any instrument is not a wise idea for any investor, regardless of their experience. It is important to consider the risk factors. For instance, if the market is in a slump, it is advisable to stay away from index funds. You’d be better off going for an actively managed option. Also, remember that given their low risk, the returns may not be as high as you’d expect. 

You should take into consideration how the fund has performed over the few years and check the year-on-year returns. Analyze the dips and try to understand if there is a reason. A good starting point would be to review the annual report to get detailed insights into how the fund has been managed.

If you are a long-term investor, index funds can be useful as it provides you with a well-diversified portfolio increasing your chances of getting sufficient returns. Stay invested for at least seven years to get maximum returns. Therefore, you should invest in them only if they are suited to your investment goals and risk appetite. 

It is also important to compare different index funds before you invest in one. Given the low cost and minimal effort involved, you are likely to do well with index funds if you are just starting your investment journey. Similarly, index funds are the perfect avenue if you have a low-to-medium risk appetite and want to enjoy gains from passive investment. Ultimately, any kind of investment should provide you with sufficient returns to make them worth it. 

If you need the advice of an expert to choose the right option for you, reach out to Moneyfront. Our team of experts is here to guide you in the right direction.