It can often be very confusing for retail investors to pick a suitable investment strategy. However, one thing that every investor swears by is to keep a diversified portfolio and never put all your eggs in one basket.

For anyone who wishes to follow this mantra, index funds can be a suitable pick for that hint of diversity in your portfolio. 

What Is an Index?

Before we get into discussing what an index fund is, it is important to understand what an index is. If you even remotely follow the stock market, you must have come across the terms “Nifty” and “Sensex”. And if you have been wondering what they are, well then, they are the benchmark indices of the Indian stock market.

Nifty is a composition of the top 50 stocks in terms of market capitalisation value, whereas Sensex is a basket of top 30 such stocks. There are various indices to represent the performance of different sectors. For example, Nifty Bank is an indicator of the top 50 best-performing banking companies in the country.

What Are Index Funds?

Index funds are a type of mutual fund that follows the performance of an underlying benchmark index. The fund managers aim to replicate the returns generated by the benchmark index by keeping the portfolio and the weightage of stocks similar to that of the index. 

Any rebalancing of the portfolio takes place on a consistent basis. Therefore, if there are any changes in the underlying index, the fund managers also change the allocation of the index fund accordingly.

However, note that we are using the term similar here and not same. There’s always a tracking error associated with such funds due to some difference in returns between an index fund and its benchmark. 

How Do Index Funds Work?

Investors often try to gain profits by copying a popular index. But because there are so many stocks in the indices, investing in all of them can turn out to be quite expensive. This is where index funds come into play. They are made up of stocks with almost the same proportion as they are in the underlying index. This makes investing in the underlying index easier and cost-effective.

Let us take an example to better understand this. Let’s say an XYZ index fund is imitating the Nifty midcap 50 index. This is an index made up of the top 50 best-performing midcap companies in India in terms of market capitalisation. 

Now, the fund manager for this index fund will invest in all 50 stocks that are a part of the Nifty midcap 50 index. So if you invest in this XYZ index fund, you will get exposure to the 50 midcap companies at once. 

Types of Index Funds in India 

At present, there are numerous types of index funds active in the country. However, for the sake of simplicity, we will stick to only six such types in this blog.

1. Broad market-based index funds: As the name suggests, this index fund makes an effort to imitate the returns of a large segment of the market. It helps investors get exposure to various sectors in the market through one investment route.
    
2. Market capitalisation index funds: The market cap of a security refers to the quantity of that security being traded multiplied by its market price. Such indices compile stocks with the highest trading volume. Nifty 50 is an example of one such index.
    
3. Equal weight index funds: These funds imitate the composition of an index but not the weightage of securities in that index. They pick the same securities but allot the same weightage to all of them.
    
4. International index funds: These funds are for investors seeking exposure to global markets. Such funds invest in international indices like NASDAQ, S&P 500 etc.
    
5. Sector-based index funds: These index funds are focused on indices of different sectors. They track indices such as Nifty Bank, Nifty IT, Nifty Energy, etc.
    
6. Debt index funds: These funds are composed of corporate debt securities or government debt securities. These are, however, not very popular in the country.

Who Should Invest in Index Funds?

Investing in index funds does not require a lot of research and analysis. Since they track an underlying index consisting of the top-performing securities, the risk factor also gets toned down. Hence, the following types of investors can choose to invest in index funds:

1. Someone who wants to imitate the returns of an index but lacks sufficient funds for the same. 
    
2. An investor seeking diversity in their portfolio.
    
3. A risk-averse investor who does not want to deal with the extreme volatility of the market and is expecting predictable returns.
    
4. An investor who does not want to constantly keep track of their investments and make changes in their portfolio accordingly.

How to Start Investing in Index Funds? 

Investing in index funds has now become a hassle-free process. There are two ways through which you can start investing in an index fund: 

Through the official website of the AMC

Step 1: First of all, you need to pick an asset management company through which you would like to start investing. Pick it based on your goals and the associated charges. 

Step 2: Now that you have made your pick, visit their official website and fill in all the required information.

Step 3: You will now have to undergo a KYC process wherein you will have to furnish your Aadhaar and PAN card details. You might also need to complete a photo verification.

Once registration is approved, you can invest in any index fund of your choice on the AMC’s website. 

Through mobile applications

There are numerous brokerage apps that you can use to start investing in an index fund. Some apps might ask you to pay a registration charge, and some might let you open an account for free. 

Step 1: Once you make your pick, download the respective app. 

Step 2: You will now be asked to fill in some personal details like name, contact information etc. 

Step 3: You will now have to undergo a KYC process similar to that of the AMC’s website. 

Step 4: Once your verification is complete, you can choose the index fund you wish to invest in. Pay the required amount to start your investment journey. 

Remember that in both cases, it might take a day or two to get KYC approval. Once you get your approval, you can easily start investing in any index fund of your choice. Also, you do not necessarily need to have a Demat account to invest in index funds.

Advantages of Investing in Index Funds 

Index funds have gained wide popularity in the past few decades. A lot of it is due to the advantages it brings to its investors. Some of them include: 

1. Low investment cost: Index funds are a far less expensive method to invest in a diversified portfolio without having to put in a huge sum of money.
    
2. Wide exposure: Since index funds are composed of multiple stocks of an underlying index, it allows investors to gain exposure to multiple sectors at once. 
    
3. Beginner friendly: Investing in index funds does not require a vast knowledge of the market or an in-depth analysis of its performance. Since they are passively-managed funds, investors do not need to take much stress.
    
4. No constant tracking: Another advantage of these passively managed funds is that the fund manager alters the funds as needed. 
   
   He/she alters the asset allocation based on the performance of the companies in the underlying index, which requires less amount of tracking when compared to actively managed funds. 
    
5. Transparency: Index funds have a transparent portfolio. You can easily avail the details of securities that the fund managers have invested in on AMC’s website. 

What Are the Disadvantages of Investing in Index Funds?

No financial instrument is entirely perfect. Every index funds have some disadvantages that come attached to it.

1. Limited returns: An index fund always imitates its underlying index. Therefore, it will never outperform the index. So, if you are someone looking for high returns, this might not exactly be the right instrument for you.
2. Implications of the index performance: Sometimes, it may so happen that the underlying index crashes. In situations like this, your index fund returns will also crash.
3. Losing on returns from high-performing stock: Your index fund consists of top-performing stocks in their respective sectors. However, this does not mean the same will directly reflect on your returns too. What you will get is an averaged-out return based on the performance of all the stocks on the index.

Things to Consider Before Investing in Index Funds 

As good as index funds sound, not every financial instrument is right for everyone. Hence, before you decide to jump into investing in an index fund, make sure you have taken into consideration the following factors:

1. Risk factor: For investors who are risk-averse, index funds can be a good choice to invest in. However, in case the market crashes, things can easily go down south because these funds lose their value in such circumstances. 
    
2. Possible returns: Returns on less volatile financial instruments never go exponentially high. They offer limited gains; therefore, invest in these funds only if you are not expecting any sky-high returns.
    
3. Tax implications: Tax implications of index funds are the same as that of any other equity funds. Depending on your holding period, you will be liable to pay taxes when redeeming your investment. You shall also be liable to dividend distribution tax in case there’s payment of dividends.
    
4. Investment strategy: As discussed above, index funds are passively managed funds. The fund manager employs no strategy as such to manage the assets; his/her only goal is to replicate the returns of an underlying index. 
    
5. Investment horizon: Index funds are a suitable choice in case of long-term investments of 7 years or more. They often fluctuate in the short run but can generate good returns over a long duration.

Conclusion 

Passive investing has become a popular choice of investment in the past few decades. Investors prefer this because of the non-biased investment strategy implemented by fund managers in these funds.

But like we always say, using your own discretion in your financial journey is very crucial. Never blindly follow anything you hear or see. Make sure to compare the different index funds before putting your money on the line.