Index funds are mirrors of stock weightage

Many such funds replicate popular benchmarks

The Bombay Stock Exchange (BSE) building is reflected on a glass window as people look at a large screen displaying India's benchmark share index on the facade of the building in Mumbai in this July 2, 2008 file photo. The Federal Reserve is widely expected to hike interest rates for the first time in almost a decade on Wednesday. REUTERS/Arko Datta/Files FROM THE FILES - BRACING FOR A FED RATE HIKESEARCH "FED RATE HIKE" FOR ALL 36 IMAGES

What are index funds?

Index funds, as the name suggests, are funds that replicate a certain index. So, if there is a Sensex fund, it will have the same 30 stocks that are there in the Sensex. Further, the weightage of each stocks in the fund would also mirror their respective weightage in the actual index. Globally, there are many index funds that replicate popular benchmarks like S&P 500 and Dow Jones. In the Indian arena, most of the leading mutual fund houses offer index funds based on Sensex or Nifty. Index funds are a form of passive funds since the fund manager does not have to actively do any kind of stock picking. The fund sees a churn in its portfolio only if the actual index sees any inclusion or exclusion.

What are the benefits of investing in index funds?

Typically, the benchmark index of any exchange would comprise the largest and most liquid companies publicly listed on that bourse. The benchmarks are quite diversified in terms of sector representation as well. So, investing in an index fund allows the investor to have a well-diversified portfolio of the largest companies. An investor can own a basket of stocks at a much lower cost compared to owning each stock individually in a benchmark.

Are index funds better than other types of equity funds?

Warren Buffet, who is widely considered as one of the most successful investors in the world, recommends index funds. Having said that, it depends on an individual’s investment approach — whether one wants to bet on the benchmark's movement or wants to play on a certain sector, or wants to invest in stocks based on market capitalisation — midcap or smallcap. Index funds, however, allow an investor to bet on the overall market, which is always measured in terms of the benchmark's movement.

Do index funds offer cost benefits as well?

As mentioned earlier, index funds are a form of passive investment instruments as fund managers do not have any active role in managing such funds on a day to day basis. So, typically, index funds have a lower expense ratio compared to an actively-managed fund where the fund manager does active stock picking. Hence, there is a cost benefit in favour of index funds.