What is an index fund?

An easy way to cook the perfect meal is to get the right recipe and replicate it. 

Likewise, in the world of investing, index funds can be called as a ready-made recipe for wealth creation. And legendary investors – from John Bogle to Warren Buffett – recommend index investing to create wealth over the long run. 

So, what an index fund is and does it work? 

Index fund and how it works

Let’s set the context first by understanding what an index is. An index is a measure of a group of stocks or securities’ performance. In India, there are two major equity indices – the Nifty50 and Sensex. These indices have companies from various industries across the economy. 

Nifty50 and Sensex are considered as the barometer for the broader markets. Besides these two benchmark indices, there are multiple other indices – from sectoral to thematic. Besides equities, there are debt or bond indices too.

An index gets created with the help of pre-set criteria that includes free-float market capitalisation. The indices are usually re-balanced semi-annually and comprise stocks across sectors. Hence, these indices work as a benchmark for passive or index investing. 

So, simply put, index funds are mutual fund schemes which track or replicate an index. These funds invest in the same companies and in the same proportion as the index.    

Should you invest in index funds?

Actively managed mutual funds have been struggling to beat index funds. Most importantly, you need to find mutual funds which can give high returns at low risk. And there are very few funds which meet these criteria. 

We found out that, of the 150 actively managed large-cap mutual fund schemes, only three schemes met this criterion. It’s a similar story in small and mid-cap space. Seven of the 39 midcap schemes and nine of the 29 small cap schemes fit the bill. 

These numbers show that it is difficult to select mutual fund schemes. But don’t worry, there is a solution to this. You can invest in index funds.  

Let’s look at the benefits of index funds: 

1. Low cost 

The primary advantage of index funds is the low expense ratio. Index funds tend to have lower management fees compared to actively managed funds. As index funds are not actively managed, there isn’t any strategy to formulate and execute. These funds replicate the markets or indices’ performance. Fund managers merely duplicate the index, and do not have to go through the trouble of analysing individual stocks.

2. No human bias

Index funds follow a passive, rule-based investment strategy. With no active investing involved, index funds eliminate the risk of human bias. 

3. Simple and transparent 

Index funds adopt a simple strategy of replicating or mimicking the index. This also ensures more transparency compared to actively managed funds. 

4. Diversification

If you invest in index funds which track the Nifty50 and Sensex, you will get exposure to blue chip companies from across the sectors of the Indian economy. For instance, the Nifty50 index has companies from more than ten sectors, including financial services, technology, and fast-moving consumer goods.

In conclusion, index funds are a low-cost and easy way to invest. They track the performance of an index, provide diversification, and eliminate human bias. They are relatively more transparent than actively managed funds and require less expertise. Therefore, index funds can be an excellent option for long-term investors looking for steady wealth creation.