What Are Index Funds and How Do They Work?

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Invest in Nifty Index Funds - What are Nifty Index

Do you look for a smart way to invest? Are you particular about finding a diversified investment? Do you want them to be tax-efficient and low-cost basket of securities? You can get all these things achieved in a bundle from Index funds. 

What are Index Funds, Are index funds Better Than stocks?

As you can understand from the name Index funds are mutual fund investments that invest in stocks. These are not regular stocks. But, they are stocks that look similar to the indexes like BSE Sensex, NSE Nifty in stock market. Index fund’s are managed passively. What does it mean? The fund manager invests in the matching securities available in the underlying index. Also, he does it in the matching ratio and does not make any changes to the portfolio arrangement. Index fund’s are committed to offering investors returns that you can compare to the index that you track.

When you invest in index fund’s, your fund manager will not play an active role in the selection of stocks and industries. He will invest in all stocks that structure the index to be obeyed. You will find one thing here. The weight-age of stocks in the index fund will match and weight-age of every stock in the index. It means that the fund manager will copy the index when building the fund’s portfolio. He will try to retain a portfolio in sync with its index at all times. What if the weight of stock within the index changes? When this happens, your fund manager will try and sell or buy units of the stock. He does it to align its weight in the portfolio similar to the index.

How are Index Funds Different from Actively Managed Funds?

Here are the key factors that differentiate index funds from actively managed funds:

Index Funds – Definition, Risk and Returns

  • Management fee: Index fund management will not cost you more. The reason is that these funds follow the benchmark of popular indexes. On the other hand, actively managed funds need continuous professional management. It means that you will have to pay a higher management fee for these funds.
  • Annual Expense Ratio: Your fund manager need not have to frequently manage index funds. So, these funds carry a low expense ratio. This is not the case with actively managed funds as they need constant monitoring. In turn, the annual expense ratio will be far higher.
  • Risk: The risk in index fund investment allies with its benchmark risk. When it comes to actively managed funds, they can turn riskier. This can happen particularly when they do not perform in line with their benchmark.
  • Objective: The objective of index funds is to counterpart the performance of a particular market index or benchmark. Actively managed funds, always try to outperform the market benchmark.

Advantages of Index Fund Investment:

You might be wondering why to invest in an index fund when there are other investment options available. But, index funds carry many benefits like those mentioned below that make investing in these funds a worthy choice:

  1. Low Costs: In index funds, the composition of a target index includes known numbers. So, as compared to actively managed fund’s, it costs less to run an index fund. Also, the expense ratio of index fund’s is very low as compared to other fund’s. All these factors contribute to lower spending when you invest in index fund’s.
  2. Simplicity: In index funds, the investment goals are easy to understand. Once you are aware of the target index of the index fund, you can identify the type of securities that hold the index fund. Also, management of an index fund is easy and you can do it once every year or once in six months. These two factors make an investment in index funds simple.
  3. Lower Turnovers: Turnover denotes the purchase and sale of securities by a fund manager. When securities are sold, they can attract capital gain taxes. At times, it is passed on to you as an investor. As index fund investments are passive, the turnovers are lower compared to actively managed funds. In turn, you are relieved of capital gain taxes.
  4. No style drift: Style drift is a concept that happens when the managed funds go beyond the purview of their described style. Managed funds do this for increasing returns to investors. These drifts can have a negative impact on the portfolio of an investor. Particularly, this can happen if you have developed your portfolio with diversified investments. On the other hand, it will not happen with the index fund.

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