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What is An Index Fund: Its Working, & Benefits

17 Jul 2023

When it comes to mutual funds, there is simply no dearth of options. You have actively managed funds, passively managed funds, equity funds, debt funds, hybrid funds, sector-wise funds, and index funds. As an investor, knowing the differences between these kinds of funds is very important since it can help you make the right investment decision. In this article, we’re going to take a comprehensive look at one of the most popular mutual fund options in India - index funds. Let’s begin by trying first to understand what it is. 

What is an Index Fund

An index fund is a type of mutual fund that’s designed to mimic a broad-market index like the NIFTY or the SENSEX. However, unlike other mutual funds that seek to outperform the market, index funds aim to merely match the performance of the index that it is based on. 

That’s why these funds feature the same companies that are present in the broad-market index that they hope to emulate. Index funds operate under the assumption that, over the long term, the broad market will consistently outperform any single stock or mutual fund.   

How Do Index Funds Work? 

Now that you’ve seen what an index fund is, let’s take a quick look at how it works. 

Since an index fund is designed to closely imitate the performance of a broad-market index, the NAV of the fund will see a positive upward movement if the market witnesses a rise. And on the contrary, if the market falls, the NAV of the index fund will see a negative downward movement. This is highly unlike a regular mutual fund, where the fund may remain unaffected or only slightly affected if the market falls and may witness a meteoric rise if the market rises. 

The Difference Between Index Funds and Regular Mutual Funds 

One of the primary differences between mutual funds and index funds is the way they’re managed. In the case of regular mutual funds, they’re actively managed by a dedicated fund manager. The fund manager is responsible for constructing and reconstructing the portfolio, timing the market, rebalancing it from time to time, and ensuring that the mutual fund meets its goals. 

Index funds, on the other hand, are passively managed. This means that there’s no dedicated fund manager who is responsible for managing the fund. And even if there is one, the manager doesn’t actively take part in the management of the fund. Once the fund is constituted, the fund house doesn’t usually make any changes to it unless the constituents of the index it is based on changes. 

Advantages of Index Funds

Now that you know what index funds are, let’s take a look at some of the advantages that you get to enjoy by investing in them. 

Proper Diversification 

Although regular mutual funds do provide investors with a little bit of diversification, it is usually far from ideal. Index funds, on the other hand, offer the maximum possible level of diversification. This reduces the investment risk considerably compared to a regular mutual fund. 

Low Costs 

The costs associated with actively managed mutual funds such as entry load, exit load, and expense ratios, tend to be much higher. This is primarily because of the presence of an active and dedicated fund manager, due to which the operating expenses of the fund go up, which are subsequently recovered from the investor. 

With Index funds, however, there’s very little work done by the fund manager, which helps keep the operating expenses low, due to which the cost to the investor also remains very affordable.  

High Long-Term Gains

When looking at long-term gains, index funds have traditionally fared far better than regular mutual funds. While mutual funds may have a few stellar years where they produce double-digit returns, it is usually very tough to sustain them over the long term. Index funds, however, typically tend to produce modest returns year-after-year. But, the returns are usually very consistent, which ultimately leads to it producing excellent returns in the long-term. 

Disadvantages of Index Funds 

You’ve seen what the advantages of index funds are, let’s now take a look at a few of their disadvantages as well. 

Very Little Flexibility 

Index funds are not as flexible as regular mutual funds. Once the fund is constituted, it hardly goes through any changes or rebalancing unless the index itself is reconstituted by the stock exchanges. In the case of regular mutual funds, however, the manager constantly rebalances the fund and reconstitutes the portfolio to ensure that it is in line with the fund’s objectives. 

Limited Returns 

As you’ve already seen before, the returns produced by index funds are generally steady, moderate, and limited. Regular mutual funds, on the other hand, can produce returns that are far greater than index funds, which can make them more appealing to investors.   

Market Swings May Affect Performance 

A well-constituted mutual fund can insulate investors from major market swings and crashes. Unfortunately, index funds don’t possess that advantage. If the broad market goes through a bearish trend, the performance of the index fund will also suffer.   

Conclusion

Index funds are perfectly suited for buy-and-hold investors and those looking to build a corpus for their retirement. In addition, if you’re interested in passive investing, you can consider purchasing units of an index fund. 

However, before you proceed to do that, first, make sure that you have active trading and a Demat account. It is a mandatory prerequisite to investing in index funds, upcoming IPOs, and other market-related instruments. 

 

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