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Index Funds: Definition, Working and Benefits

Index funds can offer a simple, low-cost, and transparent way to invest in the stock market. Read on to learn about these funds in detail.

Index funds have been around for quite some time. They are considered a robust investment instrument to diversify your portfolio and manage your risks. So, every investor should know these mutual funds, their working, and the benefits they offer.

What Is an Index Fund?

An index fund is a type of mutual fund that aims to mimic the performance of a specific market index, such as Nifty 50, Bank Nifty, etc. The fund invests in a basket of stocks representing the underlying index’s composition. However, a fund can’t exactly replicate its underlying index due to the tracking error.

Understanding Tracking Error

Tracking error is a measure that represents the deviation of the fund’s returns from the returns of the benchmark index. An index fund with a low tracking error is considered good as it indicates that it performs more closely in line with its benchmark index.

How Does an Index Fund Work?

Index funds are passively managed funds, meaning a fund manager doesn’t actively decide which stock to include in the fund’s portfolio. Instead, index funds simply invest in the same securities as their underlying index and in the same proportion.

For example, an index fund tracking the Nifty 50 will invest in all the 50 stocks that comprise that index. In the case a certain stock is replaced by a new stock in Nifty 50, the fund will also adjust its portfolio accordingly. Therefore, the fund’s performance will largely depend on how its underlying index performs.

Who Should Invest in Index Funds?

It should be noted that index funds don’t aim to beat the markets. Instead, they aim to match the returns of their underlying index. Therefore, these funds are suitable for investors who want to align their mutual fund investment returns with a specific index.

Secondly, index funds are known to be less volatile than some actively managed equity funds. So, these funds can be a good option for investors who want equity exposure but don’t want the high volatility associated with actively managed equity funds.

5 Advantages of Investing in Index Funds

  1. Low Cost

Index funds being passively managed don’t require extensive research and analysis. Therefore, they can have a lower expense ratio than actively managed funds.

  1. Unbiased Investing

Index funds utilise a systematic, rules-based investment strategy. So, investment choices are not affected by an individual’s personal stock assessment. This eliminates the potential for human bias in investment decision-making.

  1. Tax-Efficient Funds

Index funds typically have a lesser frequency of buying and selling individual securities than actively managed mutual funds. As a result, the tax liabilities on these funds can be lower, which is passed on to the unitholders.

  1. Easy to Manage and Track

Index funds have a relatively stable asset allocation compared to actively managed mutual funds. This makes them simple to manage. Secondly, it’s easy to track the performance of an index fund as you just need to compare its performance with its underlying index.

  1. Diversified Exposure

Index funds can have a diversified portfolio spanning various sectors and stocks depending on the index they track. In this way, an investor can capture the potential returns of a large portion of the market through a single index mutual fund investment. For example, investing in an NSE Nifty index fund provides exposure to 50 stocks across various different sectors.

Consider allocating a portion of your investment corpus to index funds to have a well-diversified portfolio. Moreover, investing in these funds for the long term can increase your chances of benefiting from the effect of compounding.

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