March 8, 2012 10:01 pm
what are index funds? how they are different from other mutual funds?
Dear Rajan, You already have answers from dear BanyanFA & dear Justgrowmymoney. Still I’m trying to provide my 2 cents.
On a simplistic note – I assume you are aware that Nifty or Sensex are indices in India (There are many more for industries, sectors, capital wise). Now an Index fund ‘ll invest in the stocks which are the part of the index (50 for Nifty or 30 for Sensex).
There may be 2 types of index fund. Active & Passive.
Active Index funds are those, where fund manager is investing in the same 50 or 30 stocks but not as per the original weight-age of stocks in the index.
Passive Index funds are those, where fund manager is investing in the same 50 or 30 stocks as per their weight-age in the index.
In order to understand Index Funds, you need to understand that what an Index it. India has primarily Sensex and NSE NIFTY Index. There are other sub indices based upon different industries and market capitalisation of companies. Basically an Index is computed based upon the market capitalisation of Top X countries.
Index Funds give you an opportunity to invest in an Index. Its return will be directly proportionate and in line with the growth of the underlying index which it is tracking. In order to do so, Index Funds invest in the Companies which make the Index in the same proportion. To make it simpler to Understand, if NIFTY was comprised of 3 companies such as :
Reliance – 50%
ONGC – 30%
ITC – 20%
A NSE Index Mutual fund would invest its entire funds into Reliance, ONGC & ITC in exactly the same 50, 30 & 20% proportion respectively.
As mentioned by justgrowmymoney, Index funds returns may lag behind the returns of other equity diversified funds. The primary reason behind it is because Index Funds would invest into blue chips and the rate of growth in blue chips is less than mid caps.
Index funds buy the stocks in a representative index like the Sensex/Nifty in almost the same proportion so that the return on the fund is almost the same as the market. The best way to evaluate an Index fund is by an indicator called tracking error which is the difference between the Index return and the actual return (both sides, up and down). The one with the lowest tracking error post expenses is the best fund to invest in.
Indeed if one buys Index funds for their portfolio and buys a list of carefully selected stocks that grow faster than the index they can create their own Mutual FUnd portfolio beating the market. But this is not a formula for everyone!
Buying other good Mutual Funds is a good way to wealth creation. May be after 1 decade or so we will come back to extol the value of Index funds!!
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