Index Funds – All you need to know
An index fund is a type of mutual funds that track and replicates the performance of a market index. The Nifty 50 and the Sensex are the market indexes that index funds in India may seek to track.
A market index like Nifty and Sensex measures the performance of securities (stocks or bonds) to represent a sector of the Indian economy. It is tough to choose the right stocks to invest directly. However, index funds can be considered as an indirect investment option in the market index.
What is an Index Fund?
There are different approaches by which index funds track the market index: some of them invest in all the securities of the market index, whereas others only invest in a sample of securities of the market index.
The market index uses a company’s market capitalization to decide how much weight that security will have in the index. The index fund invests in the stocks in the same weight they are present in the market index.
Market capitalization or market cap is a measure of a company’s total net worth by the value of shares. The total value is calculated by multiplying the share price by the number of shares outstanding. In a market-cap weighted index, securities with higher market cap value are given more weight while purchasing securities in the index fund.
How do Index Funds work?
Index funds generally follow a passive approach of investing which doesn’t require active management of the fund. The main objective of index funds is to maximize returns over the long run and hence, they don’t buy and sell securities very often. On the contrary, an actively managed fund often aims at outperforming the market index by purchasing and selling securities very frequently.
What are the risks associated with Index Funds?
Like any investment option, index funds are also not completely risk-free. Index Funds contain the same risks as the securities in the index it tracks. Index Funds are also subject to the following risks:
- Lack of flexibility: As compared to non-index funds, index funds are less flexible in adjusting with the price declines in the securities of the index.
- Tracking error: An index fund may not track and replicate the performance of its index perfectly. For example, if a fund only invested in a sampling of the securities in the market index, it is less likely for the fund’s performance to match the performance of the index.
- Underperformance: Due to factors including fees, expenses, trading costs, and tracking error, an index fund may underperform its index.
- No beating the market: Due to its passive nature, investment in index funds doesn’t get the chance to beat the market as the case with a good actively managed fund.
- Low growth potential: Index funds only invest in the stocks of indexed companies who have left behind their growth years. Hence, investment in an index fund does not get the benefit from the growth potential of small companies.
- Expensive valuations: Companies in the index are already well established and they were actually discovered by the market, which makes their stocks expensive. Moreover, anyone investing in an index fund will get their shares at a more expensive cost, than they have already been.
Advantages of investing in Index Funds
- Low cost: Index funds are passive trackers of the market and hence, they have a lower expense ratio.
- No fund manager error: Index funds are protected from the poor management as they are not actively managed, and simply track an index. There can be tracking error which is much lower in magnitude than an error by the fund manager.
- Efficient Market Hypothesis: There is a theory that no fund manager or investor can outperform the market in the long run. Competitors discover the price differences and price the stocks as per their fundamental values. Hence, an index fund which replicates the performance of the market may outperform the active funds in the long run.
Best Index Funds in India
A fund must be analyzed and thoroughly researched before investment. There are several qualitative and quantitative factors that determine the top index fund as per your requirements.
The following are the top 5 index funds in India depending on their performance for the past 5 years. You may choose different funds based on the holding period you would like to have.
- HDFC Index Fund-Sensex(G)
- UTI Nifty Index Fund-Reg(G)
- ICICI Pru Nifty Next 50 Index Fund(G)
- HDFC Index Fund-NIFTY 50 Plan(G)
- Reliance Index Fund - Sensex Plan(G)