Index Funds: A Complete Guide
What are Index Funds?
Index Funds are investment funds that follow a benchmark index. They aim to mirror the overall performance of the underlying index. When an investor puts money in the index fund, the said amount will be then invested in all the companies that make a particular index which in turn gives the investor a more diversified portfolio.
Index funds invest a minimum of 95% in securities of a particular index/benchmark.
[1] As of Jan 2025, Index Funds had a Net AUM of 2.76 Lakh Crore.
Benefits of investing in Index Funds
- Market Representation: These funds focus on mirroring the performance of a specific index, thereby offering broad market exposure. This helps in the diversification of your investment portfolio that tracks the overall market constituents part of the index.
- Lower Costs: Index funds typically have lower expense ratios compared to actively managed funds. As mandated by SEBI, the maximum TER that can be charged for Index Funds is 1%.
- Core Foundation: [2] As mentioned by NSE India, Index Funds are a source of investment for investors looking at a long term, less risky form of investment. It helps in building a good core portfolio that may be helpful to meet long term financial goals.
Role of Fund Manager in managing an Index Fund
The Fund Manager doesn’t play an active role in selecting constituents to build the fund’s portfolio but simply invests in all the constituents that make up the index to be followed.
In a passive investment approach, the fund manager replicates the composition of a specific index by closely aligning the weightage of each constituent in the fund with the weightage in the index. The goal is to maintain the fund's portfolio in sync with the index at all points and times.
In case of index funds tracking an equity index, if the weight of the stock within the index changes, the fund manager must buy or sell units of the stock to have its weight in the portfolio aligned to that of the index. While passive management is easier to follow, the fund may not always produce the same returns as that of the index, that is termed tracking error.
Tracking Error in Index Funds
Tracking error is simply the difference between returns generated by the fund and its underlying benchmark. Lower the tracking error, more accurately the fund is able to track the underlying index.
A high tracking error means there was a high deviation in the returns of the index fund and its underlying index. The tracking error is calculated and reported on a daily basis.
Who Should Invest in Index Funds?
Index funds may be ideal for a wide range of investors, specifically those who want to generate returns that are in line with the benchmark index.
It may also be suitable for folks who prefer to avoid investing in actively managed funds whose performance is dependent on the fund manager’s ability to pick instruments that have the ability to beat the returns benchmark.
[3] The index fund offering by Zerodha Fund House can be found on its homepage.
How relevant is it to review the portfolio in case of Index funds?
An index fund usually tracks / replicates an index and the portfolio of the scheme will exactly contain the instruments as defined in the index, so an investor will have knowledge on where the investments are made in the index fund.
Conclusion
Index funds may be considered as a long-term investment option. In the long-term, index funds may help in wealth creation. However, index funds returns may also depend on market conditions. Hence, investors have to still exercise caution and evaluate their risk appetite, future goals and the time horizon of their investments before making investment decisions.
[3]: Please note that the details provided here represent current offerings and are subject to change. This information should not be viewed as financial advice or a recommendation to invest in Zerodha Mutual Fund schemes. Investors are encouraged to consult with their financial advisor for personalized investment advice.
The Nifty indices mentioned herein are owned by NSE Indices Limited. All information is provided for informational purposes only.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully
Please note that this article or document has been prepared on the basis of internal data/ publicly available information and other sources believed to be reliable. The information contained in this article or document is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party in any manner. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article or document.
Source:
[1]: Net AUM of Index Funds
[2]: Long Term Investment
Published on Feb 27th 2025
