An index fund, also known as an index-tied or index-tracked fund, is a mutual fund that mimics an index's portfolio.
What is an Index Fund
Investors think of index funds as an instrument to diversify their portfolio – they simply give the same returns that you might get if indices were purchasable. Since popular indices are not susceptible to rapid movements, index funds are a safe bet for risk-averse investors.They simply ensure a performance that is theoretically similar to the index movements.
Because index funds are not actively managed, they are less expensive. They will not outperform an index but simply replicate its movements. They help investors diversify and balance the risk in their portfolio.
How Do They Work?
If you consider an index fund that mirror’s Nifty 50, it will contain the same stocks as the index and with the same weightage. Index funds are called as passive fund management because they simply monitor the movement of an index. Based on the composition of the underlying index, a fund manager divides your funds with the right weightage for certain stocks. Index funds, unlike actively managed funds, do not have their own team of research experts to find opportunities and pick stocks.
While an actively managed fund aims to outperform its benchmark, an index fund's goal is to mirror its index's performance. Index funds usually produce returns that are similar to the benchmark. However, there will be a marginal difference between the returns of both. This is the tracking error and it is the fund manager's job to reduce this error as much as possible.
Who Should Put Their Money in Index Funds?
As with any investment, you need to first understand your risk tolerance and investment objectives. Index funds are for those who do not want high risk but are also realistic about lower returns. If you do not have a lot of time to monitor the stock markets every year, then this one is for you. You can choose a highly liquid Sensex or Nifty index fund