In A Nutshell

Index funds are passively managed funds which track an index, such as Nifty50 or Dow Jones Industrial Average (DJIA). These hold a basket of assets of a particular asset class, such as debt, equity, or any other. Because they are passively managed, they are low cost and a relatively stable mode of investment and provide investors with exposure to several assets with ease.

Pros

• They are consistent performers and have generated decent returns over the years.
• These offer optimum transparency regarding their asset allocation.
• These are passively managed to ensure lower trading costs and minimum operating costs.

Cons

• These are inflexible, and their asset composition will only change if the underlying index changes.
• Most index funds often are subjected to tracking errors, which can cause you to get lower returns than your target indices.

Table of Contents

• Overview
• Definition of an Index Fund
• Understanding an index
• How do index funds work?
• Index fund types
• Conclusion
• FAQs

Overview

Investors have a range of investment options, each with unique earning potential and risk propensity. Investments usually come in two forms – active and passive.

While active investments require you to keep a tab on how they are performing constantly and possibly tinker with them to match your future expectations, passive investment options do not require frequent fiddling. Passive investments are a way to go for those who have little financial knowledge.

One such popular passive investment option is index funds. These are low-cost, offer diversification, and are simple enough for a layman to understand. Index ETFs and mutual funds have gained more popularity in the last few years, where investors have realized that actively managed portfolios have been unable to outperform the market or provide them with the desired returns.

This article discusses the basics of an index fund, how it works, and its various types.

Definition of an Index Fund

You cannot directly invest in an index. However, you can invest in assets that replicate the indices by matching its compositions.

The first index fund was created in 1976 by Jack Bogle, Founder of Vanguard. The primary aim was to offer a clutter-free investment option to investors who wish to avoid learning how to invest or spending time to find the right assets.

An index fund is a mutual fund type or an ETF (exchange-traded fund) which is passively managed and whose holdings track or match a particular index (say, S&P 500).

So, like any other mutual fund, an index fund is a basket of stocks, bonds, or any other asset. These are grouped to emulate a stock market or a specific portion. The underlying asset composition is usually stable and only changes when there is a change in the indices’ holding it is trying to replicate.

Understanding an Index

A market index is a hypothetical collection of securities, such as stocks and bonds. These represent a segment of the financial market and often act as the measure of the broader market.

Stock market indices are a crucial indicator of global and region-specific economics. For example, the USA alone has around 5,000 indexes, but we majorly talked about only three. Investors also take indices as benchmarks and utilize them for performance reporting.

How do Index Funds Work?

An index fund is a low-cost approach to investing. Instead of trying to beat the market (which over 90% of actively managed funds suck at!), the aim is to emulate the market returns at the lowest risk possible.

For this, index funds invest with a passive management strategy, i.e., choosing and investing in a bunch of assets to replicate the holding of a target index. Unlike actively managed funds which are constantly tinkered with, passive funds depend on a stable basket of assets. As a result, these funds’ composition is changed only when there is a change in the target index they are trying to replicate.

This way, these funds may not beat the market but will ensure the investor gains when the target indices do well. Also, given that most actively managed funds cannot beat the market, the better bet is to try and earn market gains, especially for those not willing to spend time and resources on researching.

Index Funds Types

Given the nature of index funds, we can bifurcate them across several categories. For example, even when we talk equity, we have a plethora of indices to choose from. That they also act as a market indicator means we must know about various index fund types before investing.

So, here are the most popular index fund types you need to know of –

Broad Market Index Funds

Unlike most index funds, which limit themselves to a portion of the stock market or any other investable market, broad market index funds track most of an investable segment, say stocks, debt, or any other asset. These encompass assets from all the areas of a category, say it includes both small-cap and large-cap stocks, offering a cost-optimized exposure to the entire asset segment.

Some popular broad market index funds include –

• SPDR Dow Jones Industrial Average ETF Trust (DIA)
• SPDR S&P 500 ETF Trust (SPY)
• Vanguard Total Bond Market ETF (BND)

Market Cap Index Funds

These funds track the performance based on specific market capitalization ranges. For example, small-cap funds track companies with a market cap not exceeding USD 2 billion. Similarly, large-cap funds only deal with listed brands with a market capitalization exceeding USD 10 billion.

Some popular market cap index funds include –

• iShares Russell 2500 ETF (SMMD)
• Vanguard Mid-cap ETF (VO)
• Fidelity 500 Index Fund (FXAIX)

Equal-Weight Index Funds

Most index funds aim to track an index and have a custom weight for their assets based on market cap. This means that companies worth more will automatically get a higher share in the index portfolio. While sensible, this also poses a risk: if the component occupying a larger space underperforms, the fund will find it difficult to perform well. So, how does a fund manager mitigate the risk?

By creating an equal-weight index fund! Here, the manager allocates equal weights to all the assets in the portfolio. It means that if the fund has 10 assets, each will form 10% of the portfolio.

Some popular equal-weight index funds include –

• SPDR S&P Biotech ETF (XBI)
• Invesco S&P 500 Equal-Weight ETF (RSP)
• First Trust Dow 30 Equal Weight ETF (EDOW)

Debt Index Funds

Like with equities, there are several indices globally for bonds too. Investors looking to emulate their returns can consider investing in debt index funds. These funds track bond indices and maintain a similar asset composition to their respective benchmark debt indexes. It means that the fund holds the assets issued by the same issuer and with the same duration to ensure optimum tracking efficiency.

Some popular debt index funds include –

• iShares 1–5 Year Investment Grade Corporate Bond ETF (IGSB)
• SPDR Portfolio Short Term Corporate Bond ETF (SPSB)
• Vanguard Short-Term Corporate Bond Index Fund (VCSH)

Why are Index Funds less Popular?

While index funds are terrific for those who do not want to manage their portfolio actively, solely banking on them may not be best for your finances. For example, let us talk about Nikkei 225, the Tokyo Stock Exchange (TSE) index, one of the most popular Japanese stock indices.

The fund hit its all-time high in 1989 and then breached it in 2024. Also, if someone had started investing in index funds tracking Nikkei 225 in May 2000 and remained invested, they would have made no returns in the next 20 years. The stock index hit the same value five times, most recently in March 2020. Currently, it is still trading below the high it created in 1989.

It is not a one-off example, as several indices have been caught circling a position and have generated nothing for the investors. Because of this, most people have been wary of index funds.

It is imperative to understand that while index funds may have their fair share of disadvantages, they can offer a low-risk investment that can help your portfolio generate exceptional results when combined with other asset classes.

How to Choose the Right Index Fund to Invest?

Many investors plan their investment portfolios around index funds, and as their popularity grows, there are a lot of its variants that have cropped up. Amongst the chaos, how does an investor choose the right investment for themselves? Here’s how you go about choosing the right index to invest –

Choose an Index to Track

As mentioned above, there are hundreds of different indexes to track using index funds. Most people prefer investing in broad indexes, and for more aware investors, index funds based on sectoral themes, such as IT or healthcare, can also be viable investment options. For example, the Nifty50 index is the most popular in India. Similarly, the S&P 500 is the most popular index in the US. If you want to look beyond broad indexes, you can choose to track sectoral indexes which you are bullish on.

Finding the Right Index

Once you have chosen the right index to track, there can be several indexes tracking it. It is easier to find multiple options for a broad index, but some thematic indexes often can only have a handful of provider products to choose from. Ask yourself some relevant questions to refine your choice and pick the best option available.

Which index fund best tracks the index’s performance? Next, which index fund has the lowest costs? Are there any limitations or restrictions that would hinder investment in an index fund? Lastly, are there any other index funds you can consider from the fund provider? Having the answers to those questions will facilitate your decision to select the suitable index fund.

Index funds are a No-nonsense and Effective Approach to Investment

Index funds come in different types, and you can invest in any depending on your risk propensity and expectations. Irrespective of your choice, an index fund will always be a low-cost, well-diversified option that can help reduce the overall risk attached to your portfolio.

For beginners, you can start with a popular broad market index fund and gradually diversify as you progress. Once you have experience, you can opt for the more complex sector-based market cap-based funds to leverage your investments. This will help you handle your index fund investments much better.

FAQs

How to Start Investing in Index Funds?

Index fund investing is like investing in stock markets or mutual funds. For this, you will need a brokerage account with a broker. Once you have that, you can buy the relevant ETF or mutual funds tracking your choice of indices. Thereafter, choose an amount to invest – you can opt for a lump sum or a periodic SIP depending on your investment goals and risk propensity.

What is an Example of an Index Fund?

Index funds are quite common globally. For example, the US has an S&P 500 index fund to track the top 80 US companies that are part of the S&P 500 index. Here are some of the most popular index funds globally –

• Vanguard S&P (Standard & Poor) 500 ETF — Based on S&P 500 benchmark index
• Shelton NASDAQ-100 Index Direct — Based on the Nasdaq-100 benchmark index
• Invesco QQQ Trust ETF — Based on non-financial companies in the Nasdaq-100 benchmark index
• SPDR Dow Jones Industrial Average ETF Trust — Tracks the largest 30 US firms

Are Index Funds a Good Investment?

One of the biggest reasons for investing in an index fund is that they are low cost. Given that these are passively managed, the expense ratio is significantly lower than active funds and easier to manage.

But they are not market beaters, meaning you should not expect an abnormal rate of return over a significant time span. So, an index fund is an excellent investment, but its effectiveness depends on your goals and portfolio composition.

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