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A mutual fund scheme designed to mimic the performance of its benchmark is known as an index fund. The portfolio is constructed with the exact number of stocks/constituents as in the benchmark. Moreover, the individual stock weights are precisely the same. 

In other words, the objective of an index fund, unlike an actively managed fund, isn’t to outperform its benchmark or the competition. And it wouldn’t be unreasonable to say that the index funds are expected to give you ordinary returns that anybody else in the market can earn without doing anything different. 

Benefits of index funds

  1. Easy to understand: index funds copy an underlying index 
  2. Passive management: exposes you only to market risk; there is no scheme-specific risk 
  3. Cost-effective: have a low expense ratio 
  4. Diversification benefits: depending on their type, they may offer sectoral diversification 
  5. No active tracking is required: Their performance is always on par with that of the index

How have index funds done historically in India?

Table 1: List of mutual funds following the index/passive strategy

Scheme NameAUM(Cr.)Absolute (%)CAGR (%)Exp Ratio (%)
1-Year3-year5-year7-Year10-Year
HDFC Index Fund-NIFTY 50 Plan(G)(Post Addendum)11,88720.215.015.415.414.00.40
ICICI Pru Nifty 50 Index Fund(G)6,58720.115.015.315.113.80.43
HDFC Index Fund-S&P BSE Sensex(G)(Post Addendum)6,35218.914.115.315.713.90.40
SBI Nifty Index Fund-Reg(G)5,92720.114.915.115.013.50.50
ICICI Pru Nifty Next 50 Index Fund(G)3,66930.117.414.713.516.00.70
UTI Nifty Next 50 Index Fund-Reg(G)3,02729.917.414.9  0.80
Navi Nifty 50 Index Fund-Reg(G)1,38120.2    0.26
ICICI Pru S&P BSE Sensex Index Fund(G)1,30418.814.015.3  0.35
Nippon India Index Fund-Nifty 50 Plan(G)1,26320.014.514.714.713.30.59
Bandhan Nifty 50 Index Fund-Reg(G)1,10120.014.815.515.514.10.60
NIFTY 50 - TRI-21.015.116.015.914.5-
S&P BSE SENSEX - TRI-19.414.215.816.314.4-
NIFTY NEXT 50 - TRI-31.618.215.814.717.2 

NAV Data: 19 January 2024, Source: ACE MF. For illustration purposes only, the past record isn’t a precursor to future performance. 

E Since index funds don’t involve active management, they operate at lower costs. Asset Management Companies (AMCs) pass on the benefit of cost savings to investors in the form of a lower expense ratio. 

Since holding cash in a portfolio is also an active call, index funds usually refrain from holding any cash in their portfolio unless there is unprecedented redemption pressure. 

To summarise

The index strategy safeguards you from the risk of making the wrong selection. That said, you are still exposed to market risk. 

Index funds ideally suit novice investors as well as investors who don’t want to stress out about choosing the top-performing mutual fund schemes.  

FAQs

Are there any disadvantages of index funds?

Index funds aren’t suitable for aggressive investors with a high-risk appetite looking to outperform the market through active portfolio management. If only a handful of index-heavy stocks drag the benchmark index, index funds suffer. 

 Should I invest in index funds?

A well-balanced investment portfolio gives you exposure across mutual fund schemes—actively managed funds as well as passively managed index funds. If you are new to mutual fund investing, investing in an index fund can be a good starting point for you. And even if you are a savvy investor investing in actively managed funds, index funds can give you adequate diversification benefits. 

Are index funds ideal for mutual fund trading?

Although index funds are not meant for trading and speculation. Mutual funds help you fulfil your short-term as well as long-term investment goals, depending on the scheme category.  

What is a tracking error, and how does it make a difference to index funds?

Since index funds are meant to mimic the performance of their underlying index, there is a possibility of a minor deviation. The deviation in the scheme performance vis-à-vis benchmark performance is known as the tracking error. The cash balance of an index fund and its expense ratio cause tracking errors.

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