What are index funds & how do they work?


Investing in mutual funds can be tricky at times, especially if you are a first-time investor. This is exactly the reason why most financial advisors advise investors to have a clear set of financial goals so that they are able to plan their investments accordingly. Even if you choose mutual funds as your tool for wealth creation, there are literally thousands of products to choose from and sometimes it can get a bit overwhelming for some.

For those who do not know, mutual funds are broadly categorized as active funds and passive funds. Most investors consider active funds for several reasons. Firstly, because they offer active risk management. The reason why most investors consider mutual funds is that these are a pool of funds actively managed by a team of fund managers who ensure that the fund delivers outstanding returns. On the other hand, there are some investors who are skeptical about the investment decision that fund managers take and are more comfortable in investing in a scheme that generates returns that are not influenced by any human emotion. Such investors usually consider investing in passive funds like index funds.

What are index funds?

An index fund is a mutual fund scheme that invests in a portfolio of stocks similar to the way they are listed under the index. This fund does not invest in stocks belonging to two different indexes. For example, if there is an index fund whose underlying benchmark is the NIFTY Next 50 Index then it will only build a portfolio of stocks that comprise the index without changing the portfolio composition. Of its total assets, index funds invest a minimum of 95 percent in their underlying index for tracking.

How do index funds work?

Index funds only invest in stocks belonging to a particular index like the NIFTY Next 50 or SENSEX 30. So, if an index fund invests in the NIFTY 50 Index, it will try to mimic the performance of that particular index comprising of 50 stocks.  It will not replicate the performance of any other stocks when generating returns. Although index funds have dedicated fund managers, there is very little human involvement, and the returns are free from human errors as the fund managers do not actively buy or sell or hold on to securities to generate returns.

How to invest in index funds?

Two simple and easy ways to invest in index mutual funds are by either making a lumpsum investment or through the Systematic Investment Plan.

To invest in index funds via lumpsum investing, the investor must invest the entire investment sum right at the beginning of the investment cycle. This allows them to buy more units at the current NAV but also exposes their entire investment sum to market volatility.

On the other hand, SIP lets you invest small fixed sums periodically instead of making the lumpsum sum. The investor can choose the SIP tenure which is more suitable for them. Although SIPs come in weekly, monthly, quarterly, biannually, and yearly forms, a majority of the young investors consider the monthly SIP as it allows them to save and invest a fixed sum from their monthly income. This way one might even be able to inculcate the discipline of regular investing.

Investors can even use the SIP calculator to calculate the total future returns which their SIP investments in index funds. They can even use this calculator to determine the exact sum necessary to be invested regularly for them to achieve their ultimate financial goal.