When it comes to investing, there are many different strategies that investors use to generate profits. Some investors prefer to take an active approach, picking and choosing individual stocks that they believe will perform well. Others favour a more passive strategy, such as investing in index funds.

Index funds and other passive investment products simply track various market indices, eliminating the need to pick individual stocks and time market movements to buy or sell the funds. This simple approach has several advantages for investors, including lower fees, less risk, and consistent performance over time. Find out more about passive investing and if index funds are the right fit for you.

What are index funds?

Index funds are passive investment vehicles that track a particular market index, such as NSE Nifty 50, BSE Sensex, etc. These funds do not seek to outperform the benchmark index but rather to mirror its performance.

For example, a Nifty 50 index fundtracks the Nifty 50 index and holds the 50 stocks that comprise the index. The index fund tracking Nifty will also allocate the same 50 stocks in its portfolio that make up the Nifty 50 index. Here, the fund manager does not select stocks but instead mimics the benchmark. So, the goal is to maintain the benchmark composition.

Types of index funds

There are several types of index funds, including:

  • Market capitalisation index funds that are weighted according to the market capitalisation of the companies within their portfolio
  • General market index funds that are relatively tax-efficient and mimic a significant portion of the stock market
  • Earnings-based index funds that are based on the profits generated by companies
  • International index funds that follow global indexes
  • Bond-based index funds that invest in different types of bonds

Why invest in index funds? 

Here are the four major reasons why you should consider investing in index funds:

1. Broad market exposure

When you invest in index funds, you are automatically invested in all of the companies that make up the index, thus giving you a broad market exposure. Diversification is important to mitigate risk and can help to protect your portfolio from sudden market fluctuations.

For example, the Nifty 50 index gives you exposure to 50 different companies. Thus, a drop in value for one stock will not have a significant impact on your overall portfolio.

2. Lower expenses and fees

Index funds tend to have lower fees than other types of investments, such as actively managed mutual funds. This is because they are not actively managed by a team of professionals and don’t need to conduct much research.  Hence, the resources needed to manage these funds are lesser than active funds.

3. Flexibility to invest

When investing in index funds, individuals can make a lump sum investment or opt for a Systematic Investment Plan (SIP). With an SIP, investors allocate a fixed sum to an index mutual fund scheme at regular intervals (monthly, quarterly, etc.), starting with as little as Rs. 500.

4. Better returns potential

Index funds don’t try to beat the market but just track it. This can lead to stable growth over time and less volatility. For example, the average five-year Compound Annual Growth Rate (CAGR)of an index like Nifty 50 TRI is approximately 15%.

Closing thoughts

An index mutual fund offers one of the easiest and most effective ways for investors to add exposure to equity markets to their portfolio and build wealth over the long term. You can easily invest in index funds online with minimal documentation and hassle-free procedure. But before investing, it is important to check if the fund matches your investment horizon, risk appetite, and most importantly, financial goal.