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Investment is crucial to grow your wealth and secure your financial future. While there are various investments including different types of mutual funds to choose from, investing in an entire index is a good way to get started. Index funds are a type of mutual fund that you can use to easily and cheaply invest in an entire index of companies.
So let’s know more about index funds, including their types, how they work and how to make these mutual fund investments.
What are Index Funds?
To know what are index funds, you first need to understand what an index is. An index can be defined as basket of securities such as equity shares that can offer a standardized way to track performance of investments. Examples of indices in India are the Nifty 50, BSE Sensex, Nifty 100, etc.
So, an index fund can be defined as a mutual fund that features a portfolio constructed to replicate a specific index so that it contains the same equity basket in the exact same proportions. For example, a Nifty 100 index fund will feature 100 stocks in its portfolio in exactly the same proportions as the Nifty 100 index. By replicating the exact weight of different components of the index, a index mutual fund attempts to replicate the performance of its chosen index.
This form of passive investing offers some key benefits over actively managed mutual funds like broad exposure to the equity market, lower operating expenses, and a lower portfolio turnover. This is the key reason why index funds are mostly considered an ideal core portfolio holding for long-term investments like money saved as part of retirement planning.
How Index Funds Work
Now that we know the basic definition of index funds, let us understand how they work in detail. Index Funds are a type of equity investment, so they primarily invest in listed equity stocks. These investments are chosen based on the index that the mutual fund is replicating. The index fund portfolio only changes when the benchmark indexes changes. If the fund follows a weighted index i.e. different stocks having different proportions, the fund manager may periodically rebalance the different securities to reflect the weight of its presence in the benchmark.
Investing in multiple stocks of the index helps reduce the concentration risk i.e. the risk arising from the influence of a single holding in the mutual fund’s portfolio. The basic idea is that by mimicking the index profile, the fund will potentially match the performance of its chosen index. So, typically the Index Fund will perform well when its chosen index performs well and vice versa.
Types of Index Funds
There are various types of index funds in India. Below are the types of index funds that an investor can choose from:
- Broad-Based Index funds
A broad-based index fund in India replicates one of the broad-based indices in India. For example, an index fund tracking the NIFTY 500 is a broad-based index fund. Broad-based indices are called so because it gives the investor exposure to stocks across different market caps and varying sectors. A broad-based index fund can provide a high degree of diversification to investors through a single investment.
- Market Capitalization-Based Index Funds
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Market capitalization-based indexes comprise of stocks selected on the basis of their market capitalization. Examples of such indices are Nifty Midcap 150, Nifty Smallcap 250, etc. Index funds that track such indices would primarily invest in large, mid-cap or small cap stocks based on their chosen index. Market capitalization-based Index Funds allow investors to make passive investments in stocks of specific market capitalizations.
- Equal Weight Index Funds
A way to counteract the under or over-weightedness of a market cap-weighted index is to choose an equal-weight index.
Market capitalization-based indexes comprise of stocks selected on the basis of their market capitalization. Examples of such indices are Nifty Midcap 150, Nifty Smallcap 250, etc. Index funds that track such indices would primarily invest in large, mid-cap or small cap stocks based on their chosen index. Market capitalization-based Index Funds allow investors to make passive investments in stocks of specific market capitalizations.
- Equal Weight Index Funds
A way to counteract the under or over-weightedness of a market cap-weighted index is to choose an equal-weight index. An equal weight index is one wherein every stock in an index carries the same weight.
An equal weight index is one wherein every stock in an index carries the same weight. An index fund that replicates the constituents of an equal-weight index is known as an equal-weight index fund.
- Smart Beta or Factor-Based Index Funds
Recently, factor-based type of index funds has started to gain traction. Factor-based attributes such as sales, cash flow, book value, dividend yield and P/E (Price to Earnings) ratio are metrics to build a factor-based index. Index mutual funds that replicate such indices are termed as smart-beta or factor-based index funds.
- Sector-based Index Funds
Indices can be created by selecting stocks based on specific themes or sectors like consumption, infrastructure, healthcare, technology, and banking. Index Funds that replicate such indices are termed as sector-based index funds. These schemes are ideal for investors seeking thematic investments while diversifying across multiple equity stocks.
- International Index Funds
In recent years, Indian investors have developed an appetite for international investments.
- Sector-based Index Funds
Indices can be created by selecting stocks based on specific themes or sectors like consumption, infrastructure, healthcare, technology, and banking. Index Funds that replicate such indices are termed as sector-based index funds. These schemes are ideal for investors seeking thematic investments while diversifying across multiple equity stocks.
- International Index Funds (H3)
In recent years, Indian investors have developed an appetite for international investments.
However making direct equity investments in International markets can be quite difficult and expensive. This is where an International Index Fund can provide an alternative. Using these schemes, Indian investors can get exposure to leading global indices like the S&P 500, NASDAQ 100, etc.
Risks Associated with Index Investing
- Return Volatility
If the prices of equity stocks in an index falls, the index funds will also follow suit. So, the nature of the index chosen to mirror will also have a big bearing on the return volatility of the scheme. This risk of short-term volatility also makes index mutual funds less suitable for making lump sum investments especially for short-term parking of funds.
- Low Flexibility
By replicating an index, the investors of index funds are limited to a specific selection of stocks. This selection is liable to remain unchanged unless there is a change in the index itself. This reduces the flexibility an investor might have by investing in these mutual funds.
- Governance or Business Risks
Long-term returns in equity investment come from the quality of the companies you hold as part of your portfolio. Quality, in this case, may be defined by a company's profitability, capital ratios, resilience to competition, corporate governance, and balance sheet strength. Index investments do not guard against a company slipping on any of the abovementioned factors.
Who Should Invest in Index Funds?
Typically, index funds are suitable for individuals with a long-term investment horizon. As a result, these funds tend to experience fluctuations in the short term. However, this usually averages out over the long run. So, with an investment window of 5 years or longer, you can expect the fund to perform to its fullest potential.
Most experts agree that index funds are great investments for the long-term especially when investments are made regularly using a systematic investment plan. These are low-cost options for obtaining a highly diverse portfolio with a passive index track. However, it is also important to compare different index funds to be sure that you are tracking the best index fund per your goals and at a lower price.
Typically, index funds are suitable for individuals with a long-term investment horizon. As a result, these funds tend to experience fluctuations in the short term. However, this usually averages out over the long run. So, with an investment window of 5 years or longer, you can expect the fund to perform to its fullest potential.
Most experts agree that index funds are great investments for the long-term especially when investments are made regularly using a systematic investment plan. These are low-cost options for obtaining a highly diverse portfolio with a passive index track. However, it is also important to compare different index funds to be sure that you are tracking the best index fund per your goals and at a lower price.
Frequently Asked Questions (FAQs)
1. Why should an individual invest in index funds?
When you buy an index fund, there is a diversified selection of securities in the form of one easy and low-cost investment. That's why index funds are a preferable option.
2. Is it better to invest in actively managed funds or index funds?
In developed markets like the US, index funds have historically performed better than actively managed funds over the long term. Index funds are also less expensive as compared to actively managed funds. Index funds typically carry a lesser amount of risk as compared to individual stocks.
3. Are index funds a safe type of investment?
No, index fund returns are not guaranteed so this type of scheme is not without risk. These are market-linked investments so prone to risks associated with any equity investment.
4. How do index funds work?
When you invest money in an index fund, this money is then used to invest in all companies that make up a particular index. This gives an individual a more diversified portfolio as compared to making stock purchases.
5. What type of account is required to invest in index funds?
To purchase the index funds, an investment account is a mandatory requirement and you need to do mandatory KYC to set up this account. But a demat account is not necessary to make index fund investments.
Sources:
https://economictimes.indiatimes.com/definition/index
https://www.mutualfundssahihai.com/en/what-are-index-funds
https://economictimes.indiatimes.com/definition/Index-Fund
https://www.moneycontrol.com/news/business/personal-finance/index-funds-benefits-types-and-how-to-invest-pf11-4627041.html
https://www.motilaloswal.com/blog-details/the-pros-and-cons-of-investing-in-index-funds/1874
https://www.hindustantimes.com/business/a-guide-to-index-investing-101664260692211.ht
https://primeinvestor.in/what-are-the-risks-in-index-funds/
https://www.franklintempletonindia.com/investor-education/more-about-mutual-funds/article/index-funds-meaning-benefits-how-to-invest-in-index-funds/
ARN No: Nov22/Bg/10E
Disclaimer:
The investment risk in Investment portfolio is borne by the policyholder.