What is an Index Fund?

Index fund is a type of mutual fund that aims to match the performance of a particular market index, like the NSE Nifty, BSE Sensex, or other popular indices. These funds are passively managed. The fund manager buys the same securities that constitute the underlying index, in the same proportions. They do not actively adjust the composition of the portfolio.

The main objective of an index fund is to replicate the performance of the index it follows. This tends to provide investors with broad market exposure at a relatively low expense. This also makes them a suitable option for long-term investing and disciplined wealth-building, especially for beginners. In this article, we will explain what is an index fund, how index funds work, their benefits, and more.

How Do Index Funds Work?

When investors invest in an index fund, it replicates the index it tracks. For example, if an index fund replicates the NSE Nifty 100 Index, then it will have the same 100 stocks and in the same ratio. Similarly, broader indices such as the Nifty Total Market Index may replicate a wide range of stocks across market caps and sectors. Index funds may also include equity and equity-related instruments as well as bonds, depending on the type of index being tracked. Index funds aim to match the performance of the index they follow, making them a passive investment vehicle. 

After understanding how index funds work, let’s understand the key benefits of index funds.

Benefits of Index Funds

The following are the key benefits of index funds.  

• Low Cost: As an index fund follows a passive investment approach, this keeps the management’s expenses low and also makes them affordable for investors. 
• Diversification: Index funds provide diversification. As with a single investment, they provide exposure to a wide range of stocks within the chosen index. 
• Regular Market Returns: These funds help investors earn stable and market-linked returns. 
• Low Risk of Stock Selection Errors: As there is no active stock selection involved, the possibility of choosing the wrong stocks is reduced. 
• Simple and Transparent: The index fund is simple and transparent because investors always know which stocks the fund holds, as it replicates a publicly available index. 
• Long-Term Investing: These funds are suitable for long-term investing as they have broad market exposure and low costs.  

Who Should Invest in an Index Fund? 

In India, Index funds can be a suitable option for investors who want a simple and market-linked investment approach without involving active stock selection. Generally, these funds are selected by people who want diversification, stable long-term participation, and a cost-efficient investment. Investors who prefer low-maintenance portfolios, transparency, and rule-based investing may also consider investing in these funds.  Individuals who need exposure to an entire market index rather than a single stock may also consider index funds as a part of their investment.   

Factors to Consider Before Investing in Index Funds in India 

Before investing in index funds, investors should carefully review the following factors:

• Tracking Error: A tracking error shows a gap between the fund’s returns and its benchmark index. It is important to check how closely a fund follows its index. If the tracking error is lower than it shows better index replication.
• Fund Size (AUM): If the fund size, or Assets Under Management (AUM) is higher, it may support better liquidity and help reduce tracking error because of improved economies of scale. 
• Type of Index: Index funds may track broad indices like Nifty 50 or Sensex, or sectoral indices such as Nifty IT or Nifty Healthcare. The choice should match the investor’s risk profile and financial goals. 
• Investment Method: Investors can choose SIPs for regular investing, which may help in benefiting from rupee cost averaging.

After understanding what is an index mutual fund and the factors to consider before investing in them, let’s discuss the differences between index funds and ETFs.

Index Mutual Funds vs. Index ETFs 

The table below shows the difference between ETF and index fund. 

Disclaimer: All investments are subject to market risks, economic conditions, regulatory changes, and other external factors. Returns are not guaranteed and may vary based on market performance and investment tenure. Investors should assess their risk tolerance and financial objectives, conduct their own research, and consult a qualified financial advisor before making any investment decisions.

Conclusion

Index funds provide a simple and cost-efficient way of participating in well-known indices. They work through a passive investment approach that helps keep the costs lower while offering stable, market-linked growth over time. Index funds are appropriate for investors who want transparency, long-term wealth creation, and minimal involvement in active stock selection. Before selecting an index fund, one should consider factors like tracking error, fund size, type of index, and investment method. Investors can easily explore and invest in these funds through a reliable stock market trading app, making the entire process easy and accessible.