What is an Index Fund & How Index Funds Work?

Index Funds in India – What is an Index Fund & How Index Funds Work?

Index Fund is a mutual fund which imitates stock in a particular index. These funds investments are tied to an index which the fund is imitating. Let us understand What is an Index Fund in detail.

What is an Index Fund?

Index Fund is a type of mutual fund, which invests the money as per the index it replicates. For Ex. Nifty50 Index fund invest money in the same stocks and in the same proportion as Nifty50 Index.

HDFC Bank has 11.08% weight in Nifty50 Index and Reliance Industries has 10.68% weight in Nifty50. This means that out of total investment in an Index fund, 11.08% of the total fund will be invested in HDFC Bank & 10.68% will be invested in Reliance Industries.

There are different types of an index fund which replicates different indexes such as Sensex Index Fund, Nifty Next50 Index Fund, Nifty50 Index Fund etc. These funds imitate stock investment of their index. The Index fund needs to invest in the proportion of the index, they cannot invest more or less than the index. The Nifty50 Index fund needs to follow Index Constituents of Nifty50 which are as follows

Top Constituents of Nifty

Source – NSE India

How do Index Funds work?

As mentioned above Index Funds copy their relevant index, They work as the way their relevant Index works.

Index Funds, unlike actively managed funds, do not select their investment stocks on their own, they are required to follow the index & they cannot select stocks on their own.

Whenever an Index is rebalanced its index fund needs to replicate the changes into its portfolio. ITC Ltd. now has 3.31% weight in Nifty50 Index, suppose after 6 months ITC is removed from the index and Marico is replaced by it and giving the same weight of 3.31%, then Nifty50 Index Fund needs to sell all of its Investment in ITC and buy Marico stock to the extent of 3.31% of Total Investment.

Index funds also called passively managed funds because they are not required to be actively managed and can be managed without a fund manager and research team. Therefore Index funds have a low expense ratio of 0.10%0.25% of AUM.

Who Should Invest in Index Funds?

Now that you know what are index funds and how funds work, the next question arises is that who should invest in Index funds.

Investors who are looking for market-linked returns which mean suppose in the Year 2019 Nifty50 has given 12% Return, the People who want at least 12% return should invest in Index Funds.

Index Funds do not outperform/underperform the market, they give the exact market returns not more, not less. People who are looking for beating the market returns should invest in Index Funds and should invest in Actively managed funds, these people also have a fear of underperforming the market as well, Sometimes these active funds do not get market returns as well.

Investors who are looking for lost cost funds should also invest in index funds. Low-Cost means these funds have low expense ratio. The Average Expense Ratio of Index funds is 0.2% which is much lower than compared to the Average Expense Ratio of Active funds which is 1.22%

Also Read – How to Invest in Mutual Funds?

FAQ for Investing in Index Funds

These are some of the FAQ you need to see before Investing in Index Funds.

Q1) Are you Guaranteed to make money in Index Funds?

No, there is no guarantee to make money in index funds. Index funds returns are linked with the index it replicates. Suppose some year market does not performs well index funds can also give negative returns.

Q2) Are Index funds less risky?

To some extent Yes. Index funds are less risky compared to some other actively managed funds. Index Funds replicate their index to make their investment decision while in actively managed funds fund manager decides where to invest which can be riskier at times.

Q3) Can I invest in Index funds for 3 Months?

Yes, you can invest in index funds for 3 months. But Index funds like other Mutual Funds suits long term investment for best returns & compounding benefits. In Short Term Mutual funds can be risky due to its volatility nature.

Q4) Can I Create Wealth in Index Funds?

Yes, you can create Wealth in Long term with index funds. You can use SIP, Lumpsum or STP for Investing in Index Funds and creating huge wealth over the long term.

Q5) Are Index Funds tax-free?

No, Index Funds have similar tax treatment like any other Equity fund. Gains on Index Funds held for more than 1 Year are taxed at 10% of Capital Gain and Gains on Index Funds held for less than 1 Year are taxed are 15% of Capital Gain.

Hope you are able to understand what is an Index Fund & How it works, If you have any Questions/ Queries do let us know in the comments section below & Thank You very much for Reading. 

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