What are index funds, and should you invest in them?

Blog | Mutual Funds

An index fund is a portfolio created to mimic the performance of a stock market index such as the Nifty50, the BSE Sensex, or the Nasdaq.


 

In a nutshell

  • A mutual fund requires constant management from an AMC since the aim is to beat stock market returns. Therefore, they attract higher management fees.
  • Index funds aim to match the returns of an underlying market index and require less active management. 
  • AMCs charge lower maintenance fees on index funds as they are passively managed. 

“The single best thing you could have done on 11 March 1942, the first time I ever bought a stock, was to buy an index fund and never again look at the headlines, never worry about stocks anymore.” Those words came from Warren Buffet, CEO of Berkshire Hathaway. While the Oracle of Omaha needs no introduction, some of us might wonder what an index fund is and why is the most prominent investor of our time advocating it? Let’s dive in. 

What is an index fund?

An index fund is a portfolio created to mimic the performance of a stock market index such as the Nifty50, the BSE Sensex, or the Nasdaq. Every major asset management company (AMC) develops its own portfolio based on the stocks in these indices. 

The question is why should you invest in an index fund? It doesn’t grab headlines as popular stocks such as say Reliance, Infosys, or every other IPO. However, major indices consist of companies that have good fundamentals. Index funds can consist of companies across industries or comprise multiple companies within an industry sector. This way one can diversify investments, and also doesn’t need to monitor multiple companies while making investments. 

Active or passive?
Typically, a portion of one’s investments is used to cover the administrative expenses of the AMC. In the case of regular mutual funds, a fund manager actively manages the portfolio in a bid to beat market returns. However, the fund management charges are an additional cost that the investor has to bear over and above the overheads and administrative expenses that the AMCs charge. 

On the other hand, index funds are passively managed, which means that they closely replicate the performance of an index rather than trying to beat it. As a result, in an index fund, a fund manager has a smaller role to play, and that translates to lower costs for the investor. A smaller percentage of your investment goes into paying overheads, and you keep more of the returns. 

Over the last five years, the Nifty50 index delivered returns at the average rate of 7.1%. In case you made investments in a Nifty50-based index fund back in 2015, your money would have potentially grown at or close to this rate. Of course, there’s no guarantee that an index fund will perfectly track its underlying index. Crucially, as with any instrument, it would be prudent to do your own research before making an investment.  

 

Sources:

https://www.cnbc.com/2018/05/07/warren-buffett-10000-invested-in-an-index-fund-when-i-bought-my-first-stock-in-1942-would-be-worth-51-million-today.html

https://www.investopedia.com/terms/i/indexfund.asp

https://niftyindices.com/Factsheet/ind_nifty50.pdf


Disclaimer:

The above article is purely academic in nature and aims to provide knowledge about basic trading concepts & should not be construed as an opinion or advice to invest or trade.

Mutual fund investments are subject to market risks; please read all the related documents and/or consult your investment advisor before investing.

Past performance of an investment asset does not guarantee future returns.

Companies mentioned in the article are purely for illustrative purposes and are not meant as a recommendation to buy or sell any security.