What are Index Funds, Their Types & How Index Schemes Work?

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 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.

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 index fund that replicates the constituents of an equal-weight index is known as an equal-weight index fund.

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.

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.

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.

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.

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.

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.