What is Index Fund?
Have you heard of Mutual Fund? If yes, then it will be pretty easy for you to understand what the Index Fund is. Index Fund is basically, a subcategory of Mutual Fund.
In the case of an index fund, the mutual fund manager invests in such stocks that belong to the index. In India, there are two major indexes (or indices) that show the sentiment of the market – they are Nifty & Sensex. Nifty has 50 stocks, while Sensex consists of 30 stocks. Hence, investing in an index fund means that you are investing in certain stocks that are a part of it.
Therefore, we can say that Index funds are mutual funds or ETFs (Exchange-traded funds) designed to track the market index performance. It is a passive investment form where the portfolio managers do not spend hours on the stock and rebalance analysis. Thus, index funds are considered as simple long-term investments that provide steady growth.
Characteristics of Index Funds
Here are the typical characteristics of any index fund.
- It is a stocks portfolio that shows the performance of a financial market index.
- Index funds require comparatively lower expenses.
- They require less fees than others.
- It is a passively managed fund.
- It follows a passive investment strategy.
- It is a long-term theory of investment.
- It ensures steady growth and not a large profit.
- It basically compares the risk and return of the market.
How does an Index Fund Work?
The working of an index fund is quite easy and straightforward. The mutual fund manager will not have to face any complications in managing an index fund. As mentioned above, an index fund moves forward by comparing the index itself, and hence the working is quite simple.
First, let us look at an example.
As mentioned above regarding the Nifty Index, we need to note that it has shares like Reliance, Maruti, Infosys, Nestle, ACC, HDFC Bank. Now, when you invest in the Nifty index, the mutual fund manager will invest your money in the same percentage and in the same company that is present in the Index.
So, ultimately if you have Invested Rs. 100,000 in an index fund, and the next day if Nifty is 1% up, then your portfolio value will be 101000. Similarly, if Nifty is down by 1%, then your portfolio value will be 99000. From here, it is understandable that your return will be directly proportional to the return of the index.
Thus, whenever there is a change of any stock in the index, the mutual fund manager will do the same in the index fund. It’s essential to understand this concept when every time the stocks are included in and excluded from the index. So, you don’t have to worry. If some company is going wrong, then it will be excluded from the Index, and a better company will replace it.
A recent example is YES BANK and Shree cement. When the Yes bank crisis occurred, it was thrown out of the Nifty index, and Shree cement replaced its position.
Types of Index Funds
You may have read of many types of index funds, like the broad market based, international market based, market capitalisation based, etc. However, strictly speaking, there is no separate type of index fund. Index fund merely follows the index. There is the gold index fund if you are interested in investing in gold. If you want to follow Nifty, then you may invest in the Nifty index fund. Similarly, if you prefer Dow Jones, then invest in an index fund that follows Dow Jones. But remember, for the best results and according to legendary investors, invest in mainstream index funds.
Here’s something that counts as the best piece of advice; right from the desk of experience:
If you live in India, you may invest in the Nifty Index Fund.
If you live in India and want to invest in the US, then there are funds which invest in Dow Jones, S&P 500, and Nasdaq. You can invest in them.
Is it Safe to Invest in Index Funds?
When thinking about safety, the one main thing that comes to the picture is ‘risk.’ Risk management is the most important thing when considering an investment. So, what is your risk-taking capability? Is it high or low? Put in another way, can you take a risk? Do you prefer Fixed Deposit or Mutual funds?
If you prefer fixed deposits only, then your risk-taking capability is zero. You can’t see losses.
If you fall into this category, then, from a general point of view, Index Fund is not safe for you. Because the index can go down. It may consolidate or crash. In these scenarios, you will suffer losses in a short term.
Thus, we can conclude that index fund is not safe for those who don’t take a risk even of 1%. Index fund is an attractive option to invest for one who has no problem in taking a little risk.
Best Indian Index Funds
Now here’s a list of the best index funds Indians can invest in for 2021. here are the current top 5 index funds to invest.
- Nippon India Index Fund – Sensex Plan: This fund mainly aims at replicating the Sensex composition. It can bring returns according to the performance of the Sensex. It was launched two decades ago and is a moderately high-risk fund. Its return has been roughly 8.9% since its inception.
- LIC MF Index Fund Sensex: This fund will generate returns based on the performance of the Sensex or Nifty. The investment may be either in the Sensex or Nifty. It has shown 13.5% returns since its launch.
- ICICI Prudential Nifty Index Fund: In this fund, the investment will be done in a combination of select stocks from among the Nifty constituents. It is an open-ended reward scheme based on the changes in the S&P CNX Nifty Index.
- UTI Nifty Index Fund: It is a sort of ‘passive’ investment scheme aiming at making a benefit by investing in select companies that comprise the Nifty 50 Index. It brings returns commensurate with the performance of the Nifty 50 and minimizes the capital differences between the scheme and the Nifty 50.
- Franklin India Index Fund Nifty Plan: This is another fund whose objective is to make gains by investing in the companies that have Nifty shares. The returns will be according to the growth of the Nifty 50 under the NSENifty scheme.
Best US Index Funds
Now here are some of the US counterparts of the best index funds.
- Fidelity ZERO Large Cap Index: This fund helps bring down costs for the investor. It follows the Fidelity US Large Cap Index instead of tracking the S&P 500 index. It is also a zero expense ratio fund.
- Vanguard S&P 500 ETF: This fund that started a decade ago is backed by one of the great powers in the industry, Vanguard. It tracks the S&P 500 index, as is evident from the name.
- SPDR S&P 500 ETF Trust: This option, which is a pioneer in the ETF investing industry, has hundreds of billions of funds. It is sponsored by State Street Global Advisors, a big name in the industry, and tracks the S&P 500 index.
- iShares Core S&P 500 ETF: This is one of the names that have been tracking the index closely over the years. Its existence has been since two decades ago. Its sponsors are BlackRock, one of the big names in funds in the US.
- Schwab S&P 500 Index Fund: Schwab commands tens of billions in assets. Though its weightage is not as much as the above names in this list, investors nevertheless consider the name as highly important. The sponsor is Charles Schwab, a well-reputed name in the industry. The fund has been in existence since 1997. The name Schwab is well-known for creating investor-friendly propositions all the time.
How to Buy Index Funds?
In India, there are two ways in which you can invest in index funds.
- Through Mutual Funds Route
- Through ETF (Exchange-traded funds)
Let us go into the detail of both to know more about how the business runs in each way. Go through the following carefully.
- If you go through the mutual fund route, then you only have to choose a scheme that will invest in the index. For example – UTI Nifty Index Fund. This fund invests money in the index.
- If you go through ETF, then you can buy them from the secondary market. The secondary market allows you to buy or sell them. Different ETFs are available in the Indian stock markets. For example – NiftyBees. If you buy this ETF, you are investing in Index ultimately.
For Which Kind of Investors are Index Funds The Best?
The following are the characteristics of the investors to whom the Index Fund is most suited.
- You follow Warren Buffett and his principles.
- You don’t want to become rich overnight.
- You don’t expect a 30-40% return. Because the Index Fund doesn’t give these returns. The average return of the index fund is 12-18%.
- You can hold or buy them for a long period.
- You don’t want to park your money for 4-6% in bank deposits.
These principles are, in fact, based on a strong understanding of the nature of index funds. Based on deep research and study concerning the characteristics and features of index funds, one can analyse and evaluate these points and find out that they are indeed very much appropriate and valuable for anyone who has some basic knowledge about index funds and looks forward to investing in it.
When did the Index Fund Start and What Is Its History?
In India, it was IDBI Principal that started the first index mutual fund. It fundamentally tracked the Nifty index. It later got transformed to Principal Nifty 100 Equal-Weight fund. Niftybees is an ETF (exchange-traded fund) index started by Benchmark AMC. Goldman Sachs India later acquired it, which was then again acquired by Reliance Mutual Fund. Reliance then went on to collaborate with Nippon.
As per the 1960 edition of the Financial Analysts Journal, it was Edward F. Renshaw and Paul J. Feldstein that suggested the idea of an index fund for the first time. They were both students of the University of Chicago back then. Though it was not full-fledged index funds as we know it today, the new concept paved the way for the new instrument which became established in a decade.
Richard A Beach and Walton D. Dutcher Jr. of Qualidex Fund, Inc., a Florida-based concern, started a new fund based on the concept as an open-end instrument for diversification and to approximate the Dow Jones Industrial Stock Average performance. It could be practically considered the first-ever index fund in history.
John Bogle is also one of the pioneer names to consider when one thinks of the history of index funds. His research of 1951 when he was a student of Princeton University dealt with concepts that had a similar nature to index funds. Later, in 1975, based on his concepts, he started a financial establishment by the name, ‘First Index Investment Trust.’ Though it was criticized by the competitors on many fronts, it earned 17 million dollars in its first five years. Later, he renamed the fund as the Vanguard 500 Index Fund. It helped track the Standard and Poor’s 500 index. The fund found enormous success in a short time. In 1986, Vanguard came up with the first bond index fund.
Advantages of Index Funds
Well, without advantages, there wouldn’t be this primary focus on index funds, and thousands of people wouldn’t be investing in index funds. These benefits are meant for the general public. They are not individual encounters or for a specific period. Go through the following points to be aware of the advantages the index fund offers to its investors.
- Low risk
A primary advantage of the index fund is that the risk is relatively low while investing in it. It can be regarded as a low-risk option among the various kinds of investment options. If you are investing in sectors like bonds or stocks, then you are doing just the right thing. These are well diversified, and they also represent many different sectors within a particular index. And this, ultimately, results in the protection against any kind of losses.
- Steady Growth
Considering the previous point, if we look at it closely, we conclude that when there are almost zero chances of losses; you are only left to grow steadily. It is not possible in this field that you are investing and are moving parallel with no actual growth. It is just the opposite. The bonds and stocks are designed in such a way that they imply steady growth with time. Index funds are said to perform better than the majority of current non-index funds that compete in the market.
- Low Fees
Index funds require comparatively lower fees in investments than the non-index funds. However, there are certain reasons why the non-index funds demand higher fees than the index funds. One of them is that the non-index funds encounter more number of transactions than the index funds. While index funds are passively traded to let them stick to a particular index, non-index funds are actively managed.
Disadvantages of Index Funds
And this is a law of nature that when there’s an advantage there’s a disadvantage too. And here are the disadvantages of investing in an index fund.
- Lack of Flexibility
We say there’s a lack of flexibility because the managers of the index funds follow certain policies and strategies that leads them ultimately to enjoy comparatively less flexibility than the non-index managed funds. There are also several constraints of the investment decisions to be made. These constraints are due to the matching index returns. On the other hand, the managers of the actively managed fund have greater flexibility to act upon profits and losses, unlike the index fund managers.
- No Large Gains
As mentioned earlier, index funds leave most of the chances for steady growth. It does not outpace the market in a way like managed funds do. So, you should not expect a massive gain if you are investing in index funds. Some of the best non-index funds perform better than the index funds when the performance was analysed for a year, though it varies from year to year. But, the growth of the index fund, in most of the cases remains steady. It is the best possibility considered today.
Historical Returns from the Index Fund
If we talk about India, we have a benchmark index that is called Nifty 50. So, let’s check a fund which focuses on this index. We shall calculate its historic return as well.
This fund comes under SBI AMC and is managed by Mr Ravi Prakash Sharma.
So, if we see its historic return, then it is as under
It is not advisable to focus more on the 1-year return as the objective is never for a short term. The market gave a big rally after Covid. So you can see 18% return in one year. Otherwise, it’s more difficult. But yes, you should check the 5-year performance. Doing good in one year is accidental, but if a fund performs continuously, it will reflect in the 5-year return. The 5-year return of this fund is 14.98 or almost 15%. It’s excellent return considered in the mutual fund industry.
Let’s check another fund house and its performance.
This fund house comes under the UTI AMC and is managed by Mr Kaushik Basu. Its historic returns are as under:
You can see that there are minor differences in return based on tenure. But the returns are almost the same as the nifty index return to investors as mentioned above.
Now, after looking at a few designs of the Indian market, it is high time you also had a look at the US market to simplify as well as broaden your views to let a comparative understanding to sink in. Let’s check an index fund of the US Market.
This ETF follows the S&P 500, which is a benchmark index of the United States.
Check out the 10-year return of this index fund. You can say it’s 13.82%, which doesn’t seem to be a big deal, compared to the above two Indian tables. However, it is not what it appears to be. The big deal is that in the US, inflation is less than 1%. So, the investors are earning almost 12% per annum. But in India, inflation is around 4-5%. So even if our fund gives a return of 15%, we will only earn 10%.
So, to sum up, on an average you can expect your index fund to give you a return of 13-18% in the long run.
Index funds are a great way to invest if you want steady growth. It is the ultimate source of diversification and has low expense ratios as compared to other actively managed funds. The index fund is highly beneficial and ideal for passive and buy-and-hold investors. However, there are also disadvantages attached to the index funds, like they are vulnerable to crashes, and there is a lack of flexibility. The limited or steady gains make for another con though it is the primary characteristic of the index fund whatsoever. As with any investment option, one needs to learn the concept thoroughly to understand its advantages and be aware of its pitfalls. Thus, if you are familiar with the key features and invest prudently, the index fund will be a steady investment in the long run and mark a safer way for you indeed.
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