Index Mutual Funds: From types to advantages; all you need to know

Index funds are investment vehicles designed to track a benchmark index. Their objective is to replicate the overall performance of the index they follow. When an investor places money into an index fund, the funds are allocated across the companies that constitute the chosen index, thereby offering a diversified portfolio. 

Index funds typically invest at least 95% of their assets in the securities of a specific index or benchmark. As of October 2024, the Net Asset Under Management (AUM) of index funds was ₹2.67 lakh crore.

How do index funds work?

Index funds function by meticulously tracking the performance of specific benchmark indices, like NIFTY 50 or SENSEX. The process begins with the fund manager selecting an index that aligns with the fund’s investment objectives. They then acquire all or a representative portion of the securities that make up the index, ensuring the portfolio reflects the index’s weight distribution. 

Whenever the index undergoes rebalancing, the manager buys or sells securities to adjust the portfolio accordingly. This passive management approach helps lower operational costs compared to actively managed funds, which results in more affordable expense ratios. By mirroring the index, the fund’s portfolio aims to produce returns that closely match those of the underlying index over time.

Different types of index mutual funds

To fully understand index funds, it is essential to be aware of the various types available in India. Some of the popular categories include:

• Broad market index funds – These funds track a wider market segment. Examples include index funds based on Nifty 100 or Nifty 500 indices. They provide exposure to a larger variety of stocks across different sectors.
• Market capitalisation index funds – These funds invest in companies of various market capitalisations, including small-cap, mid-cap, and large-cap stocks, to achieve broad diversification.
• Equal weight index funds – For example, in the Nifty 50 index, each of the 50 stocks typically has different weightings. In an equal-weight Nifty 50 fund, each stock in the index would be given equal weight, such as 2% each, regardless of its market capitalisation.
• Sector-based index funds – These funds focus on specific sectors by investing in stocks of companies within the same industry. For example, index funds based on the Nifty Bank, Nifty PSU, Nifty Technology, or Nifty Healthcare indices.
• International index funds – These funds track foreign indices like the S&P 500, Hang Seng, or NASDAQ. They are ideal for investors seeking to diversify their portfolios internationally and gain exposure to global markets.

Advantages of investing in index mutual funds

• Market representation: These funds aim to reflect the performance of a specific index, providing broad market exposure. This diversification helps investors build a portfolio that mirrors the general market, as represented by the index.
• Lower costs: Compared to actively managed funds, index funds usually have lower expense ratios. According to SEBI guidelines, the maximum Total Expense Ratio (TER) that can be charged for index funds is 1%.
• Core foundation: As stated by NSE India, index funds are suited for long-term investors seeking a less risky investment option. They provide a stable core foundation for a portfolio, which can be crucial for meeting long-term financial objectives.

Role of fund manager in index fund management

In an index fund, the fund manager does not actively select the securities to include in the fund’s portfolio. Instead, the manager invests in all the components of the benchmark index. Adopting a passive investment strategy, the fund manager replicates the composition of a specified index, ensuring that the weight of each constituent in the fund aligns with the index. 

If the weight of a stock in the index changes, the manager adjusts the fund by buying or selling stocks to maintain alignment. While passive management is straightforward, there may be instances where the fund does not exactly match the returns of the index, known as tracking error.

Tracking Eeror in index funds

Tracking error refers to the deviation between the returns of the fund and the returns of the underlying index. A lower tracking error indicates the fund is closely following its benchmark. Conversely, a higher tracking error signals a significant deviation from the index’s performance. The tracking error is measured and reported daily.

Who should invest in index funds?

Index funds are suitable for a broad spectrum of investors, especially those who want their returns to mirror the performance of the benchmark index. They are also ideal for investors who prefer a more passive approach and wish to avoid the volatility and risks associated with actively managed funds, where performance depends on the fund manager’s stock selection.

The importance of reviewing an index fund portfolio

Although an index fund tracks a specific index and its portfolio mirrors the index’s components, reviewing the portfolio can still be beneficial.

Portfolio disclosures on the Asset Management Company (AMC) website help build trust, as investors can understand any slight variations in the passive fund’s portfolio. While the disclosures may not be as detailed as those of actively managed funds, they still provide essential information to make informed investment decisions. Investors can compare different index funds tracking the same index to choose the one that aligns best with their financial goals.

Conclusion

Index funds are generally regarded as a long-term investment option. Over time, they can contribute to wealth creation. However, returns from index funds are still influenced by market conditions. Therefore, investors should assess their risk tolerance, future financial goals, and investment time horizon before making any decisions.

Rohit Gyanchandani is Managing Director at Nandi Nivesh Private Limited