How does an Index Fund work?

Retail investors should have a diversified financial portfolio because spreading your investments helps balance risk and reduce market volatility. While diversifying their portfolio, an investor can consider investing some amount in index funds. In India, index funds are picking pace slowly as more and more people are becoming aware of their below-average expense ratio. As the name suggests, index funds are a type of investment funds that replicate the composition of the underlying market index, like the NSE NIFTY50 or BSE Sensex.

This article aims to explain the concept of index funds and how they function in the stock market.

What is an index fund?

Index funds are a good option for investors who have a long-term investment horizon. As mentioned earlier, index funds have the same composition as the underlying index, and hence moves up and down in tandem with the underlying index. So if you invested in NIFTY50 and the market goes up by 7% this will have a positive impact on your index funds. At the same time, if the market fails to perform and goes down by 5%, this will have a negative impact and your index funds will fail to make profits.

How do index funds work?

Each stock is allotted a certain weight in the market index and even index funds give the same weight to that particular stock in the fund. For example, if you invest in a specific Index fund and company ‘A’ is allotted 5% weight and company ‘B’ is allotted 10% weight, index funds will also invest in the same weight-age in those company stocks. Depending on their performance and the performance of similar company stocks in the index will have a direct impact on the performance of your index fund.

As you could have noticed by now, there is no effort being put in to select the investment stocks for an index fund. Which means that fund managers have no say in index funds. Future inflow in the fund is invested in the same proportion as that of the index. Mimicking the market index, index funds have low expense ratio rate as compared to actively managed funds. On average an actively managed funds charge a fee of around 2 percent which may vary from the type and size of the fund. On the contrary, index funds charge as low as 1 percent from its investors. This helps retail investors as they are paying less expense ratio as compared to actively managed funds.

In an index fund, a minimum of 95 percent of the corpus is always invested in the securities of the underlying index. This kind of mutual fund investment exactly suits an investor who is investing for a longer period of time. So if your investment goal is the long term your financial expectations could be aligned with the objectives of an index fund.

Index funds can be a good choice for ‘know-nothing’ investors who want to invest in the stock market but do not know how to go about it. They are also generally preferred by seasoned investors who want to diversify their financial portfolio and have a long-term investment horizon. Download our mutual fund app today to learn more about how mutual funds work.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.