Index fund is an investment instrument which invests in a basket of securities that, replicates the composition of a market index, like Nifty, Sensex, Bank Nifty, CNX – 100 and CNX – Midcap etc. Just like diversified equity mutual funds,index funds are also managed by Asset Management Companies (AMCs). However, unlike diversified equity funds, the fund manager of an index fund do not aim to beat the benchmark index as the primary objective of an index fund is to reduce the tracking error with respect to the index it is benchmarked to.
For retail investors, replicating an index by buying the stocks which comprises the Index, is difficult to execute and will require good investment. Index funds give investors the opportunity to invest in an index with a small amount without having to worry about market movements. Investors can hold index funds for as long as they want to benefit from the long term market appreciation.
Even though diversified equity mutual funds aim to diversify unsystematic risks by diversifying upto a large extent, there still is some likelihood of unsystematic risk in diversified equity mutual funds. This is because diversified equity mutual fund portfolios do not exactly reflect the benchmark portfolio composition.On the other hand, Index funds, are only subject to market risks, since they reflect the market portfolio.
Read what are diversified equity mutual funds?
Compared to diversified equity mutual funds, the expense ratios of index funds are much lower as index funds are passively managed. Diversified equity funds are actively managed funds. Therefore, over a long investment horizon higher expense ratios can make a substantial adverse impact to investor’s total returns.Those investors who are happy with Index like returns, Index funds are the best investment options at a low cost. However, investors should note that, since index funds are passively managed funds they are likely to underperform versus top performing actively managed diversified equity mutual funds in the long term.
Difference between Exchange Traded Funds (ETF) and Index Funds
Many investors use Exchange Traded Funds (ETFs) and Index funds synonymously. Purely from the standpoint of investment objectives, Index funds and exchange traded funds (ETFs) are very much the same. Exchange Traded Funds (ETFs) like Index Funds invest in a basket of stocks which replicate the index. Like Index Funds, Exchange Traded Funds (ETFs) are passively managed and aim to track the index. Despite the similarities, there are differences between the two funds which investors should clearly understand.
Exchange Traded Funds (ETF) has hybrid characteristics as it invests in both stocks and mutual funds. Also, Exchange Traded Funds (ETFs) can be bought and sold only on the stock exchanges. Investors need demat and trading accounts to invest in Exchange Traded Funds (ETFs). While there is no need of a demat account to invest in index funds as they are bought and sold like any other regular mutual fund schemes.
Would you like to know what are Exchange Traded Funds (ETFs)
Since ETFs trade on the stock exchanges, the prices change on a continuous real time basis while Net Asset Values of Index Funds are priced at the end of the day like any other mutual fund scheme. Therefore, investors can take advantage of intraday volatility (buying at the low point of the day and selling at high point of the day) in ETFs.
Some popular Index funds are – HDFC index Fund Sensex Plan, Reliance Index Fund Sensex Plan and SBI NIFTY Index Fund
However, you cannot invest in ETFs through Systematic Investment Plan. However, you can invest in Index Funds through Systematic Investment Plan. Exchange Traded Funds cost less as they have lower expense ratio compared to the Index funds.
Exchange Traded Funds (ETFs) and Index Funds serve the same investment objectives. If you have a demat account, you can invest in Exchange Traded Funds (ETFs)as it has lower expense ratios, however, if you do not have a demat account then you can achieve the same investment objectives by investing in index funds.
You may also like to read what are equity mutual funds and their different types
