What Is Index Fund?

In today’s time, investing in the stock market has become an important part of our financial growth. The stock market can be quite confusing for new investors but index funds serve as a great entry point for investing in it. By investing in index funds, people who do not have much knowledge of the stock market can get the benefit of good returns. In index funds, you invest in a mutual fund that tracks a stock index. This is a simple way of investing to diversify your portfolio. Through today’s article “What is Index fund” we will understand the concept of index fund well and know how investing in it is beneficial for us.

What is Index Fund?

Index funds are a type of mutual funds which track the performance of a stock index like Nifty 50, Nifty Bank etc. It is a copy of a stock market index which gives you almost the same returns as a stock market index. Now the question in your mind will be that what is this stock market index?

You must have heard about Nifty 50, Nifty Bank or Sensex. This is all a stock market index. There are thousands of companies listed in the stock exchange and it is not possible to track the daily movements of everyone. For this reason the stock market index was created. Some of the leading companies of the country are included in the stock market index which are listed and traded in the stock exchange. Now since these are leader companies, we can estimate the status and direction of the entire stock market from their average performance. The two main indices mentioned above include top 50 companies in Nifty 50 and 30 companies in Sensex.

As already mentioned, an index fund is a copy of a stock index. For example, Nifty 50 ETF, which is built on the basis of Nifty 50, will also include the same 50 companies and will be included in the same ratio as in the Nifty 50 index. Now, whatever Nifty performs, we can expect the same returns from the index fund.

How does an index fund work?

As mentioned above, an index fund is an exact copy of its base stock index. Whenever a mutual fund company has to start an index fund, it first selects a stock index on the basis of which it has to make stock selection. Stock exchange includes many types of indices according to the sector and nature of companies like Nifty Pharma, Nifty Psu, Nifty Transport etc. A mutual fund house selects a stock on the basis of a stock index and invests in it in the same proportion as it is included in an exchange.

Index funds are called passively managed funds because they do not need to be managed daily. Changes are made only when a stock is removed or included from the index or its ratio is changed.

How to invest in index fund?

You can invest in index funds both online and offline. Like investing in any common mutual fund scheme, investing in index funds is very easy. To invest online, you can use any discount broker like Grow, Etmoney, Zerodha Coin etc. By creating an account in these, you can easily invest in index funds and stocks etc. without any extra charges.

Another option for online investment is AMC i.e. Mutual Fund House’s own website. That is, if you want to invest in the index fund of any AMC, then login to the website of that AMC and after following a few easy steps, invest in the index fund. For example, if you want to invest in HDFC’s index fund, then you can know about it and invest by visiting the website of HDFC Mutual Fund.

To invest offline in index funds, you will have to take help from AMC office or any mutual fund agent. You can invest in these index funds by submitting the application form and necessary documents.

Why invest in index funds?

Diversification: Index funds, as mentioned earlier, are copies of their base stock index and include more than one stock. For this reason we get the benefit of diversification in index funds. Diversification reduces the loss and risk in our portfolio to a great extent.

Low expenses: Index funds are passively managed funds because no research or analysis of stocks is done to manage them. Due to this, the expense ratio of the fund also reduces, which further increases the return potential of our investment in the long term.

Ease of tracking performance: To track the performance of investments in index funds, we do not need to learn any separate skill or take help from any expert. You can track your investment returns simply by tracking the performance of the base stock index.

Ease of investing: Investing in index funds is very easy as it is available in almost every AMC and broker in both offline and online modes. For this reason, you can easily invest in it without any hassle.

Beneficial for long term investors: Only those people who have long term perspective invest in index funds. Mostly it has been seen that stock indices give positive returns in the long term.

What is the difference between Index Fund and Mutual Fund?

Both index and mutual funds are good means of investment but there is a lot of difference in their functioning and management. Let us know how index funds are different from mutual funds:

Management: Index funds are only passively managed funds because they are created only as a copy of their base index and they only copy its performance. The same mutual funds can be of both active and passive types. In this, the main objective of the fund manager is to invest people’s money in the market in such a way that it can give better returns than the benchmark index.

Expense Ratio: Being passive managed funds, the expense ratio of index funds is much lower than that of mutual funds, whereas mutual funds can be of both active and passive types. In active mutual funds, the fund manager has to constantly make changes to the fund as per the market conditions, hence its expense ratio or fee is higher than that of index funds.

Performance: Index funds are copies of their base stock index, hence their returns also depend on the performance of the stock index. On the other hand, the performance of a mutual fund depends on its management and the quality of the assets invested. The effort of the fund manager of a mutual fund is that the returns of the scheme should be more than the benchmark index and the investor should get maximum profit.

Tax Benefit: According to index funds, mutual funds are tax efficient because their returns are also low due to which the investor does not have to pay much capital gains tax. The case tax rate of a mutual fund depends on its returns and its type. The tax rate is different in case of debt and equity mutual funds and it also depends on the return on investment and the investment objective of the scheme.

Diversification: The benefit of diversification in an index fund is limited only to the sector of which the benchmark index is a copy. That means, if an index fund is a copy of Nifty Bank, then only banking and financial stocks will be included in it. We also get the benefit of diversification in mutual funds, but each of its schemes is prepared under the supervision of the management keeping in mind an investment objective. For this reason, the scope of diversification in mutual funds is slightly more than that of index funds.

Conclusion

Index funds allow even an investor unfamiliar with the market to take advantage of stock market returns. Overall we can say that index funds are a simple and economical way of investment. Its objective is to provide you a good return from old methods of market investment like FD, RD etc. which can beat inflation. This is a better option for long term investors than short term. We hope that this article has helped you to understand index funds better.