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What is an Index Fund & How Does it Work?

  • Apr 18, 2024

An index fund is a type of mutual fund that simplifies and makes investing in a complete index of equities from various industries affordable. Now, let's learn what is an index fund and how does it work, what is low cost index fund, its types, their operation, and how to invest in it.

What are the Best Index Funds?

An index mutual fund invests in equities that mimic stock market indices such as the BSE Sensex, NSE Nifty, etc. These funds are passively managed, meaning that the professional fund manager doesn't alter the composition of the portfolio. Instead, they make the same proportional investments in the same assets included in the underlying index. The aim of these funds is to offer returns that are in line with the index they follow

How do Index Funds Work?

After learning the fundamentals of index funds, let's take a closer look at their operation. Since index funds are a kind of equity investment, their main source of capital comes from listed equity stocks. The mutual fund's selection of these investments is determined by the index it is copying. Only when the benchmark indexes fluctuate does the portfolio of index funds alter. Should the fund adhere to a weighted index, whereby distinct stocks possess varying amounts, the manager of the fund may periodically rebalance the various securities to mirror their relative weight in the benchmark.

Purchasing several index stocks lowers the risk associated with concentration or the impact of a single holding on the portfolio of a mutual fund. The main premise is that the fund may be able to equal the performance of its selected index by imitating the index profile. Thus, when the selected index does well, the index fund will usually do well as well, and vice versa.

Who Should Invest in an Index Fund?

The returns of index funds are comparable to those of the index because they follow a market index. Thus, these funds are preferred by investors who want to engage in the equity markets without incurring many risks and who seek predictable returns. In an actively managed fund, the portfolio's composition is altered by the fund manager in response to his evaluation of the underlying stocks' potential performance.

This increases the portfolio's level of risk. These kinds of hazards don't exist because index funds are managed passively. The returns won't, however, be significantly higher than those provided by the index. Investing in actively managed stock funds is a superior choice for investors looking for bigger returns.

What are the Types of Index Funds?

There are varied types of index funds, which we will discuss below: -

1.Broad-Based Index funds

An Indian broad-based index fund replicates this index in India. A broad-based index fund would track the NIFTY 500, for instance. The reason broad-based indices are named such is that they expose investors to equities from a variety of industries and market capitalisation. With just one investment, investors can get a high level of diversification with a broad-based index fund.

2. Smart Beta or Factor-Based Index Funds

Factor-based index funds have become more popular recently. Metrics used to construct a factor-based index include sales, cash flow, book value, dividend yield, and P/E (price to earnings). Investee index mutual funds that mimic these indexes are called factor-based or smart-beta index funds.

3. Equal Weight Index Funds

Selecting an equal-weight index can help offset the under- or over-weightedness of a market cap-weighted index.

Every stock in an index with the same weight is said to be in an equal-weight index. An equal-weight index fund is an index fund that mimics the components of an equal-weight index.

4.Market Capitalisation-Based Index Funds

Stocks chosen for market capitalisation-based indices are based on their market capitalisation. These indexes include the Nifty Midcap 150, Nifty Smallcap 250, and others. Large, mid-cap or smallcap equities would be the main investments made by index funds that track these indexes, depending on the index they have selected. Investors can make passive investments in stocks with particular market capitalisations through market capitalisation-based index funds.

The Bottom Line

An investment that seeks to mimic the performance of a particular market index is known as an index fund. It has a number of benefits, including accessibility, minimal costs, steady returns, and diversification. Index fund investing is best suited for a long-term investment strategy and can be done in a number of ways. Before making any investing decisions, you should carefully evaluate your own goals and risk tolerance.

Team Sharekhan
by Team Sharekhan

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