What are Index Funds?
Before delving deep into Index funds, you need to know about the stock market Index. A stock market Index reflects the relative value of a group of stocks. When the value of the stocks in a particular Index change, so does the cumulative value of the Index.
Stock indices are often considered as a means of gauging how the market is performing as a whole. NSE Nifty and BSE Sensex are two the popular stock indices in India, which are made up of 50 and 30 stocks respectively.
Index funds are mutual funds that invest in all stocks in a particular Index, in the same proportion as in the Index. Consequently, they offer returns that are mostly equal to the Index return, minus a small fee.
So, if you invest in an Index fund that mirrors the BSE Sensex, the fund will invest in the same 30 stocks, in the same proportion, as held in the Sensex. Hence, the fund’s performance will mostly be at par with the performance of that Index. Similarly, sector-specific Index funds can be used to invest in particular sectors, like pharma (e.g. Nifty Pharma Index) or auto (e.g. Nifty Auto Index).
Benefits of Index Funds
- Low Total Expense Ratio
This is one of the major benefits of Index funds. Index funds are ‘passively managed funds’ since their portfolio is a replica of the Index. Their total expense ratio (determined by dividing a fund’s operating expenses by the average rupee value of its assets under management) is lower than actively managed funds.
Consequently, they incur lesser expenses in the form of fund management fees (as compared to an actively managed funds). Overall, these funds offer the advantage of low cost to investors.
- Offers Diversification and Easy Management of Portfolio
With stocks from various sectors, Index funds offer excellent diversification. As markets become more efficient, beating benchmarks can be difficult. In such a scenario, Index funds might work out as a lucrative investment idea. While traditionally, Index funds were favoured by conservative investors, today such funds are finding their place in several retail portfolios.
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