What Are Index Funds? How Do They Work? Who Can Invest?

What Are Index Funds- How Do They Work- Who Can Invest
What Are Index Funds- How Do They Work- Who Can Invest


Index Funds are passively managed funds that permit you to participate in the stocks market. Index funds allow you to invest in an index. The term index analyses the fact that you cannot buy shares directly, but you can buy shares from entities and companies which are part of an index. S & P 500 is the most widely invested index which contains the largest 500 US companies in the New York Stock exchange based on their market capitalization.


A passively managed fund can be described as one that does not require any form of analysis of the performance of the stock that is resident in the stocks. In actively managed funds, the managers employ fundamental technical analysis to precisely predict the performance of future stocks. Passively managed funds X-rays the true image of the index.


In selecting a fund, you should be able to compare its performance characteristics from different angles. There are some data you can use to determine the best index funds you desire. Nevertheless, never forget the risk that can occur in any financial investment.

The table below indicates the top 5 performing Index Funds in India based on their return on investment for the last 5 years.

Name of Fund 1 year 3 year 5 year
UTI Nifty Index Fund 16.69 10.46 13.41
IDFC Nifty Fund 16.57 10.40 13.54
HDFC Index Fund 16.59 10.41 13.59
Aditya Birla SL Index Fund 15.28 9.35 12.68
Franklin India Index Fund 15.16 9.58 12.77


There are things you must always bear in mind before selecting an investment option as Index Funds. These are:

  • High rates: it is best to invest in the fund based on the duration you require and not on the highest returns.
  • Financial status: note that people have a different financial condition. Evaluate the funds and select the type that suits your financial capability and not based on the fund’s popularity.
  • Ensure to use a systematic investment plan which is a better and safer investment option.
  • Investments in direct plans for mutual funds offer higher returns than the regular fund schemes.
  • Try your best to review your investments at least once a month.
  • Ignore the myths; be scientific in your approach to investments.



ClearTax has made investments in Index funds easier and quicker without any paperwork. The following are the steps you need to take to invest in Index Funds.

  • Log on to cleartax.in and create your account.
  • Insert your details with special attention to the amount of investment and the duration of funds.
  • Implement your e –KYC within 5 minutes
  • Select the appropriate index fund among the available mutual funds.


When a benchmark like Nifty is tracked by index fund its portfolio is made of the exact proportions of the 50 stocks in Nifty. An index is a merger of securities that make up a market segment.

These securities can be equity-oriented instruments like stocks or bond market instruments. Most popular India indices are the NSE Nifty and BSE Sensex.

Index funds track a particular index, which makes it fall under passive fund management. The stocks to be bought or sold in accordance with the composition of the nascent benchmark are decided by the fund manager.

Unlike actively managed funds, index fund matches its performance to the index it tracks and delivers returns which can be more, equal or less than the benchmark.

In most cases, there can be a difference between the index and the fund performance which brings about what is called a tracking error.

It is the duty of the fund manager to control the tracking error by bringing it to the minimum level.


What can inform your investment decision in Index funds is your investment goal and risk appetite?

If you can manage risk and can endure long-term investments, then Index fund is for you. Any investor with interest in getting his returns exactly as can be predicted can invest in index funds.

There is minimum tracking in an Index fund. An example of this is when you decide to invest in equities but does not wish to bear the risk that comes with that venture then you can opt for a Nifty or Sensex index fund.

These funds will provide the exact mirror of the index it sees. To earn returns based on the trading condition of the stock markets, you can decide to invest in actively-managed funds.

In the short-run, the returns of index funds may match that of actively-managed funds, but over a long period, actively-managed funds perform better.


The following are the things that will determine your choice of investment in Index fund:

  • Risk taking: index funds are less prone to equity related market risks since they mirror an index. When the market is tending towards generating huge returns, index funds comes as the ideal option. When the market is about to slump, it is wise to switch to actively managed funds. Index funds have the tendency to lose its share during a market downturn. Having both actively-managed funds and index funds in your portfolio is the right move to make.
  • Funds Return: index fund tracks the performance of the benchmark of its index in a rather passive mode. The purpose of this method is not to override the benchmark, but to bring about the exact image of the performance of the index. Due to tracking error, the funds return may not match that of the index. Knowledge of funds with the minimum tracking error is what will help you to invest in the best index funds. The secret is simple and that is ‘the lower the tracking error of the fund, the better the performance will be.
  • Expense ratio: in many instances, index funds’ expense ratio can be 0.5% or less while actively managed funds have between 1% to 2.5% expense ratios. This is because index funds’ portfolio is not managed actively and the managers may not have to come up with any investment plans. What distinguishes two index funds is the expense ratio. For example, when Nifty is being tracked by two index funds, there is every tendency that both of them will have similar returns. The fund with a lesser expense ratio offers a marginally high return.
  • Investment Plan: index funds are for you if you have a long-term investment plan. In most cases, the fund becomes very unstable in the short-term averages. However, it offers returns in the range of 10% to 12% in the long-run over a period of 7 years and above. Making index funds as an investment choice demands patience so it could yield its dividends on maturity.
  • Financial Investment Goals: index funds, as well as mutual funds, can serve as a means of achieving the expected investment goals especially in planning for retirement. These funds can generate the needed wealth which you can use to enhance your life after retirement.


The following are the advantages of index funds which give it a comparative advantage over other types of equity funds which are:

  • Low cost: managing an index fund is less expensive because the target quantity is predetermined compared to an actively managed funds.
  • Simplicity in formation: understanding the investment objective of mutual funds is very easy. The only thing that an investor should be concerned with is the target index and type of securities the funds can hold.
  • Lesser turnovers: turnovers in this context refer to the trading of securities by the fund manager. In many jurisdictions, selling securities could result in capital gains tax which is undertaken by fund managers. Because index funds are not actively managed, the turnovers are less.


The following are some of the disadvantages of index funds to an investor.

  • Losses due to index of arbitrage: to match the new prices and the market capitalization of the current securities in the indexes that they track, index funds must rebalance from time to time. Funds that are tracking an index are announced before they trades are made causing the values to be carried by arbitrageurs through a practice known as ‘index front running’.
  • General market impact: uncertainty sets in when a large pool of resources is used to track the same index. In theory, a company should not be wealthier than the index it partakes. Because of the laws of demand and supply, there is the tendency that a company in the index has a higher demand and if a company is removed, it can have an increased supply and thus affects the price. This will not be reflected in a tracking error because the index is affected. The impact on a fund can become low if it is tracking an index with low popularity.
  • The possibility of occurrence of tracking error: because indexes are directed to match market returns, a difference in the performance compared to the market is a tracking error. In a failing market system, a non-performing index fund will generate a positive tracking error.





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