How Does an Index Fund Work?

Looking to learn about index funds to invest in? You’re in the right place. This article will explore what index funds are, how they work, their objectives and whether you should be parking your money in them.

What is an index fund?

Also known as index-tracked or index-tied mutual funds, these funds imitate a market index’s portfolio. This means index funds strive to replicate their underlying market index components– like the Nifty or the Sensex.

Here, the funds are passively managed, which means your fund manager parks funds in the same list of securities as present in the underlying index. They don’t change the portfolio composition as well. The best index funds can typically provide returns comparable to the index they’re tracking.

Additional Read – How To Invest in Index Funds in India – All You Need to Know About Index Funds

How do index funds work?

It’s important to note that index funds track particular indexes and are not actively managed, and this is why they incur low expenses. Since they track an index, they don’t outperform the market. They help investors balance the market-linked risks in their investment portfolio.

Let’s explore this in detail.

Let’s say an index fund is tracking a benchmark like the Nifty. This means the portfolio will have 50 stocks that constitute Nifty in similar proportions. Here, at all times, the index’s portfolio mirrors that of the underlying index, even in their percentage holding. Thanks to this correlation, the index fund’s NAV moves virtually in line with the index it is tracking.

The best index mutual funds aim to deliver returns somewhat similar to its underlying benchmark. However, even when index funds replicate the market movement, the returns can be marginally lower than the index they are tracking. How? That’s because of a variation known as the ‘tracking error’. Tracking error is affected by inflows/outflows in the fund, change in index constituents, corporate actions, and the level of cash in the fund.

When shortlisting the best index mutual funds to invest in, it’s prudent to ensure that the tracking error is at the minimum. Why? That’s because the lower the error, the better the fund’s performance.

Additional Read – What are Index Funds? Are Index Funds Returns High?

Who should invest in index mutual funds?

As a long-term investor, if you want to park funds in equity securities for wealth creation over time but are uncertain about the role of fund managers in the process, you can choose index funds. However, investing in these funds is well-suited for you if your investment horizon can extend up to 6-7 years.

Since index funds take a passive investing approach and are less aggressively invested, they are less volatile. So, index funds are best suited for risk-averse investors in the market for predictable returns.

However, you must invest in actively managed fund schemes during a market downturn to generate consistent returns. That’s because index funds lose value during a market slump, and therefore your portfolio should have a mix of actively and passively managed funds.

Over to you

When looking to start investing in index funds, it’s best to compare multiple schemes, understand your risk appetite, and decide on an investment horizon before proceeding. With Tata Capital’s Moneyfy app, align your financial goals with your investments today!