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An “index fund” is a type of mutual fund or exchange-traded fund that seeks to track the returns of a market index. The S&P 500 Index, the Russell 2000 Index, and the Wilshire 5000 Total Market Index are just a few examples of market indexes that index funds may seek to track.

A market index measures the performance of a “basket” of securities (like stocks or bonds), which is meant to represent a sector of a stock market, or of an economy. You cannot invest directly in a market index, but because index funds track a market index they provide an indirect investment option.

Index funds may take different approaches to track a market index: some invest in all of the securities included in a market index, while others invest in only a sample of the securities included in a market index.

Market indexes often use a company’s market capitalisation to decide how much weight that security will have in the index. Market capitalisation (or “market cap”) is a measure of the total value of the company’s shares. The total value is equal to the share price times the number of shares outstanding. In a market-cap-weighted index, securities with a higher market capitalisation value account for a greater share of the overall value of the index. Some market indexes, such as the Dow Jones Industrial Average, are “price-weighted.” In this case, the price per share will determine the weight of a security.

How do index funds invest?
Index funds have generally followed a passive, rather than active, style of investing. This means they aim to maximise returns over the long run by not buying and selling securities very often. In contrast, an actively managed fund often seeks to outperform a market (usually measured by some kind of index) by doing more frequent purchases and sales.

What are some risks of index funds?
Like any investment, index funds involve risk. An index fund will be subject to the same general risks as the securities in the index it tracks. The fund may also be subject to certain other risks, such as:

Lack of Flexibility:
An index fund may have less flexibility than a non-index fund to react to price declines in the securities in the index.
Tracking Error:
An index fund may not perfectly track its index. For example, a fund may only invest in a sampling of the securities in the market index, in which case the fund’s performance may be less likely to match the index.
Underperformance:
An index fund may underperform its index because of fees and expenses, trading costs, and tracking error.

Benefits of investing in index funds

1. Low fees
Since an index fund mimics its underlying benchmark, there is no need for an efficient team of research analysts to help fund managers pick the right stocks. Also, there is no active trading of stocks. All these factors lead to low managing cost of an index fund.

2. No bias investing
Index funds follow an automated, regulation-based investment method. The fund manager is provided with a defined mandate of the amount to be invested in index funds of various securities. This eliminates human discretion/bias while taking investment decisions.

3. Broad market exposure
Investing money in a proportion similar to that of an index ensures that the portfolio is diversified across all sectors and stocks. Thus, an investor can seize the probable returns on the larger segment of the market through a single index fund. For instance, if you decide to invest in the Nifty index fund, you enjoy investment exposure to 50 stocks spread across 13 sectors, ranging from pharma to financial services.

4. Tax Benefits of Investing in Index Funds
Since index funds are passively managed, they usually enjoy low turnover, i.e. few trades placed by a fund manager in a given year. Fewer trades results in fewer capital gains distributions that are passed to the unit-holders.

5. Easier to manage
Since fund managers do not have to worry themselves with how stocks on the index are performing in the market, index funds are easier to manage. A fund manager just needs to rebalance the portfolio periodically.

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