What Are Index Funds And How Do They Work?

“These are good times, the market is doing pretty good”, “Look at Nifty go, man the market is up this week”, “Man, did you take a look at Sensex? Market’s pretty down” and others like this are just some of the phrases suited up gentlemen on any market analysis channel or video toss around while laymen like us are left wondering what these terms even mean, let alone understand the full implication of what they just said. But, what are Nifty, Sensex and other indices? What is their purpose and how are they created? How are mutual fund portfolios connected to these indices? These are just some of the topics we are going to discuss in this article.

What Is An Index?

An Index, put in simple terms, is a sample. This sample is used to try to get an accurate idea of how well or bad the economy of a particular country or how a specific industry of the country is performing.

Suppose you want to determine how well a country’s economy is performing. It is impossible to make a portfolio that consists of and tracks the stocks of each and every company listed across all the stock exchanges of the country, right? So, what to do? Economists try to solve this problem in two ways. 

• The first way is that they try to determine the composition of the economy sector-wise, i.e. what sector contributes what percent to the country’s economy and try to replicate the same composition in their portfolio. This way, it can be said that the portfolio’s performance represents the economy’s performance since it is a sample of the economy at large itself. 

• The other way is that they create a portfolio that just contains the stocks of the top contributors to the economy. This can be an accurate approach too since a sector making up a certain percentage of the economy does not equate to the sector making a proportionate contribution in the economy’s revenue. 

The top 30 or 50 companies, on the other hand, have effects that are large enough to drive entire economies. If the economy’s top companies are doing well, it can be concluded that the economy of that country as a whole is doing well, regardless of whether the smaller companies are doing well or not and vice versa. 

In practical life, the second approach is more popular, and that is why we see our country’s two most popular indices - The National Stock Index Nifty 50 and The Sensitive Index (more popularly known as “Nifty” and “Sensex”) track the performance of the top 50 companies listed on the National Stock Exchange (NSE) in terms of market capitalization and of the top 30 companies listed on the Bombay Stock Exchange (BSE) in terms of market capitalization, respectively.

In a similar manner, when one wants to track the performance of a particular sector, a portfolio trying to replicate the sector is curated. Some of the examples are Technology Sector Indices (e.g. Nifty IT and S&P BSE IT), Healthcare Sector Indices (e.g. Nifty Healthcare and Nifty Pharma), Financial Sector Indices (Nifty Bank and S&P BSE Bank) and Energy Sector Indices (Nifty Energy and Nifty Oil & Gas). The performance of the portfolio is used to judge the performance of the sector and is very useful information to investors and analysts.

What Is An Index Fund?

Now that we have understood what an index is, understanding what index funds are is going to be much easier. Just as indices try to replicate the composition of a country’s economy or that of a sector, index funds replicate and try to replicate the performance of the market index that they are tracking. This means that the index funds choose securities in their portfolio in a similar manner as the index that they are tracking chooses its stocks, and hence the gains made on the fund are similar to the gains made by indices.

Types Of Index Funds

Just like Market Indices are classified as per the types of stocks they are made up of, index funds can also be classified on the same criteria. An even better way to understand the classification of Index Funds is to understand the various types of indices first, and then look at what type of index is the index fund tracking or trying to replicate.

The following are the types of index funds we shall be discussing in this article:

Sector Index Funds:

Some market indices are used to gauge the performance of a particular sector of the economy. For example, the NSE IT Index, which comprises the top 20 IT companies listed on the National Stock Exchange in terms of market capitalisation and liquidity, is used to track the performance of India’s IT Sector and serves as a measuring scale for investors to measure the performance of their portfolio in the IT Sector. It is clear that an investment fund that tracks the performance of this NSE IT Index by replicating its composition in its own portfolio will be called an IT Sector Index Fund. Some examples are the Energy Select Sector SPDR Fund, Health Care Select Sector SPDR Fund and Financial Select Sector SPDR Fund.

Broad Market Index Fund:

Index funds that try to replicate market indices that gauge the performance of the entire economy of an economy as a whole, for instance, The NSE Nifty or Sensex, and hence try to recreate a performance similar to the performance of the economy of the country are called Broad Market Index Funds. Some examples include the S&P 500 Index Fund, Nifty 50 Index Fund and Dow Jones Industrial Average Index Fund.

Value Factor Index Fund:

This is a fund that tries to identify the stocks listed on the stock exchange at an undervalued price. The goal of a value factor index fund is to create a portfolio that consists of stocks that the index fund recognises as undervalued so that they can be bought while they are undervalued and as the market realises their true worth, their value appreciates, giving the fund holders greater returns and hence, outperforming the market. Fund companies like Kotak, HDFC, ICICI etc provide such funds to the investors in the Indian market. 

Geographic Index Funds

Some funds also provide investors the option to invest in the stocks of a particular region. For instance, an investor may recognise the potential for growth in a specific country like India and consecutively want to invest in companies listed in that particular country. So, a geographic index fund will create a portfolio containing all its investee companies from that particular country, which is in this example, India. For example, the iShares MSCI India ETF has a portfolio made up entirely of Indian stocks. The iShares MSCI EAFE ETF has in its investment portfolio only the developed market stocks in Europe, Australia, and the Far East.

How Do Index Funds Work?

Index funds do to market indices what market indices do to a country’s economy or a particular sector of the economy. From what you have read so far, it must be clear that market indices try to replicate the composition of the economy of a country or that of a particular sector in order to gauge their performance by replicating their results. Those results are in turn replicated by the index fund that tracks that market index by copying its list’s composition in its portfolio and hence tracks its performance against the performance of the market index, effectively comparing its performance with that of the economy or the sector itself. 

The following are the characteristics of an index fund:

1. The first thing to do is to decide what market index is the index fund going to replicate. Whether it is going to be a broad market index fund, a sector index fund, or any other.

2. Once the market index is selected, the next step is to analyse the percent composition of the index in terms of what companies make it up - their sector, market cap, liquidity etc. and then create an investment portfolio that replicates the composition of the index, essentially creating a sample of the market index’s composition.

3. Since a market fund invests in portfolios trying to replicate the composition of a market fund, it can be said that it is trying to replicate its performance rather than trying to outperform it. This is called passive management. In passive management, the fund’s investment portfolio simply copies the composition of a market index already present in the market and hardly any changes in the composition are made for the entirety of the investment mandate. On the other hand, active management requires the fund manager to constantly track and predict the performance of every stock and the potential replacement for it and needs to keep changing it as and when required to try to outperform the market (i.e. market indices) with as much margin as possible.

4. It is obvious that passive management is much easier and requires much less effort and experience in comparison to active management. Hence, funds that are actively managed charge a higher fee than those which are passively managed. Since an index fund is passively managed, the fee paid on it is relatively lower.

5. Since a market fund invests in a large number of stocks, it leads to diversification leading to a lowering of the investment risk. However, if the index fund is tracking a specific sector index, the diversification may be somewhat compromised at times when the entire sector goes through stages of business cycles where it performs poorly.

How To Invest In Index Funds

Investing in index funds is a very simple process since index funds, at the end of the day, are mutual funds only. In case the index fund in question is a mutual fund, it can be invested in by following the steps we have mentioned under the section - “How To Start An S.I.P. in Mutual Funds” in our article - “How To Start An S.I.P. in Mutual Funds?” The article can be accessed here: https://www.insurancedekho.com/investment/news/how-to-start-an-sip-in-mutual-funds-10371?v=1725871268268

However, sometimes the index fund may be present in the form of an Exchange Traded Fund (E.T.F.). E.T.F.s are funds that are traded on stock exchanges and hence can be bought and sold on the stock market. They are also more flexible when compared to mutual funds.

Frequently Asked Questions

1. What are E.T.F.s?
   E.T.F.s as their name suggests, are funds that are traded on exchanges. This means they are investment funds in their nature but like individual stocks, they are traded on the stock exchanges. Since they can be traded on the stock exchange like stocks, they are more flexible and more liquid.

2. What is a business cycle?
   Although the concept requires proper explanation, all you need to know for your intents and purposes is that every economy goes through highs and lows. Highs are times of economic prosperity when the GDP is high, employment is high and so is consumer spending. Lows are periods when the economy declines, GDP falls and so does employment and consumer spending. The economy keeps shifting between these highs and lows with their respective peaks and troughs and the process keeps repeating, hence getting the name business cycle.

3. How can the performance of sectors be determined by which stage of the business cycle the economy is in?
   The answer has to do with the spending power of the public and how it changes in different stages. When the economy is in the expansion phase, for example, consumers tend to spend more so a company that manufactures and sells automobiles would perform well as more and more people buy new cars. On the other hand, in the contraction stage, a company making spare parts for automobiles would do well since the consumers’ spending power has decreased and they would rather get their car fixed than buy a new one.