Index Fund: Definition, History, How it Works, and Types

Index funds are mutual or exchange-traded funds (ETFs) designed to track a specific market index. Index funds provide investors with an easy and cost-effective way of diversifying and mitigating risk associated with individual stock investments.

Index funds have been around since John Bogle introduced the Vanguard 500 Index Fund as the inaugural retail index fund back in 1971. His goal was to offer low-cost investments that allowed investors to achieve market returns without incurring high costs from active fund management. These passively managed investment options have become an integral component of many investors’ portfolios over time.

Index funds work by replicating the composition of a specific market index. A Nifty 50 index fund would invest in identical stocks proportionately as those within it. This passive strategy seeks to match rather than surpass the performance of its respective index by selecting individual stocks. Index funds hence tend to have lower management fees and operating expenses when compared with actively managed funds.

Equity index funds are one of the most prevalent types of index funds in India. These funds follow stock market indices such as Nifty 50, BSE Sensex or Nifty Midcap 100 indices to gain exposure to all or specific segments of Indian stocks such as large-cap, mid-cap or small-cap stocks. Equity index funds offer investors long-term growth while accepting volatility as part of investing.

Debt index funds are another popular type of index fund in India, tracking bond market indices like the Nifty Composite Debt Index or CRISIL Composite Bond Fund Index. Debt index funds provide exposure to government, corporate and municipal bonds as an investment option,  making them suitable for investors seeking income or seeking more conservative returns than equity index funds.

International index funds are designed to track global or regional stock market indices such as the MSCI World Index or MSCI Emerging Markets Index, providing Indian investors with exposure to international stocks that diversify portfolios beyond domestic investments. Such funds offer Indians exposure to potential growth opportunities available abroad while being mindful of risks such as currency fluctuations and political instability that come with investing internationally. 

Sector-specific index funds provide investors with a way to target investments in specific sectors of India’s economy – be they technology, healthcare or financial services. Investors who hold strong convictions about certain industries or sectors find these investments to be the ideal way to align their investments with their convictions.

What exactly is an Index Fund?

Index Funds are mutual funds or exchange-traded funds (ETFs) designed to closely mirror or track an index of financial market assets such as the Standard & Poor’s 500 Index (S&P 500). An index fund seeks to mimic the performance of an index by investing in similar stocks and assets that make up that index, in proportions that match up exactly with how it’s calculated. Such passive strategies provide low costs with broad market exposure and diversification benefits. Index funds do not seek to outstrip or beat other funds. Their goal is to mirror a particular benchmark index’s performance. This passive management approach necessitates less frequent trading and lower turnover, thus decreasing transaction costs and taxes for investors. Index funds are also known as passively managed funds since their primary investment objective is to track an index rather than actively selecting individual securities.

An index fund is an investment vehicle that pools money from multiple investors to purchase a diverse portfolio of stocks, bonds or other assets. Mutual funds either are actively managed – with an advisor making decisions regarding which securities to buy and sell – or passively managed, like index funds which aim to mirror an index’s performance.

The main benefit of index funds is that they typically have lower expense ratios compared to actively managed funds. This means investors keep more of their returns which add up over time and lead to superior long-term performance. Index funds also provide diversification by offering exposure to an assortment of stocks or assets within an index, helping reduce the impact of poor performances by individual securities on overall portfolio returns. Their passive management reduces risks related to human error or bias that might otherwise arise with active management strategies resulting in more consistent long-term performance.

What is the Origin of Index Fund?

Index funds have their roots in the 1960s and 70s when academics and financial professionals began questioning active investment management practices. Index investing was pioneered through Efficient Market Hypothesis (EMH), which states that stock prices reflect all publicly available information so actively managed funds cannot consistently outshone market returns. Index funds were first proposed by economist and Nobel laureate Paul Samuelson in his 1974 paper “Challenge to Judgment”. Samuelson asserted that passive investment strategies, like index investing, had a greater chance of outperforming active management in terms of lower costs and market efficiency over time. Bogle’s creation of an index fund stemmed from his belief that investors would benefit more by owning a broadly diversified portfolio that mirrored the market than by trying to outwit it through active stock selection. He sought to give individual investors access to low-cost investment solutions that enabled them to take advantage of market returns without incurring higher fees associated with actively managed funds.

Vanguard 500 Index Fund (now Vanguard S&P 500 ETF), was introduced as the first retail index fund on August 31, 1976, and initially met with great skepticism from many critics. Some even called it “Bogle’s folly”. But passive investing methods like index funds gained popularity with investors over time, as their performance demonstrated the advantages. Other investment management firms also began offering them as the advantages of index funds became clear.

How does Index Fund work?

Index investing works on the principle of the Efficient Market Hypothesis (EMH), which asserts that financial markets are efficient and that stock prices already reflect all publicly available information. Active fund managers find it challenging or impossible to consistently outperform the market when factoring in expenses associated with active management fees and expenses. But index funds employ a passive investment approach with minimal trading activity and lower turnover resulting in reduced costs and improved long-term returns for investors.

It’s crucial to first gain an understanding of financial market indices to fully understand index funds. An index represents a statistical measure reflecting the performance of specific segments in a financial market such as stocks, bonds or commodities. Indices are typically designed and maintained by independent index providers who establish the methodology for selecting and weighing securities within an index. Indexes that have become widely known over time include the S&P 500, which measures the performance of 500 large-cap U.S. stocks. The NASDAQ Composite, which encompasses all companies listed on this stock exchange, etc.

Investors purchasing shares of an index fund are effectively buying a small piece of the entire market or market segment represented by its underlying index. This means its portfolio will reflect that of its index in terms of holding securities in similar proportions. 

Index funds take either of two forms: open-end mutual funds and ETFs. Open-end mutual funds issue and redeem shares according to the net asset value (NAV) of their fund at the end of every trading day, which investors purchase either directly from or via a broker. Prices are determined at that time. ETFs, on the other hand, trade throughout trading hours like individual stocks with supply and demand pricing systems which allow investors greater flexibility than open-end mutual funds when buying and selling them at any point during market hours allowing more flexibility than open-end mutual funds.

What is the importance of Index Funds?

Index funds provide an easy and straightforward means of diversification for an investment portfolio. Index funds allow investors to gain exposure to different companies, sectors or asset classes with one single investment, helping reduce risk while mitigating adverse performance by individual securities. Index funds offer advantages over active management mutual funds when it comes to costs. These funds require less active management, thus leading to lower management fees and operating expenses, and ultimately having an impact on long-term returns over time. 

Index funds are also highly accessible to investors of all kinds – from retail investors to institutional. They could be bought and sold easily on mutual fund platforms or traded directly on stock exchanges in the case of ETFs. This provides access for a wider array of investors looking for long-term growth potential in markets. They are highly transparent investments because their composition is determined by publicly available market indices. This allows investors to easily understand the underlying holdings and associated risks, as well as track its performance relative to its benchmark index. Index funds are more tax-efficient than actively managed funds in some cases, particularly ETFs. This is due to lower portfolio turnover and consequently fewer capital gains distributions which are subject to tax.

Index funds have played an instrumental role in driving a shift away from active investing towards passive strategies, with their increasing popularity leading to an overall shift from active to passive investment strategies. Demand has skyrocketed leading to more assets under management for passive strategies as more investors recognize the advantages of low costs and long-term performance offered by index funds.

What is the purpose of Index Funds?

Index funds provide investors with a straightforward, cost-effective and diversified investment solution designed to track a market index. These funds allow investors to participate in either broad market returns or returns specific to a segment of the market depending on which index is selected. Index funds generally follow a passive approach, meaning they replicate the performance of an index rather than attempt to outdo it by picking individual stocks or bonds. This approach has numerous advantages including reduced costs, decreased portfolio turnover, and more predictable results. Index funds’ primary function is to offer instantaneous diversification for investors. 

Index investors are able to spread out their risk across many companies, sectors or asset classes, decreasing any negative impacts due to poor individual performances by individual securities. They are designed to be cost-efficient, offering lower management fees and operating expenses than actively managed funds due to less research, analysis, and trading activity required of passive managers. Investors benefit from these cost savings which have the potential to have an impressive effect on long-term returns. They are also highly accessible to both retail and institutional investors alike, making participation easy in markets with long-term growth potential. They are easily bought and sold through mutual fund platforms or stock exchanges allowing investors to participate quickly in long-term growth potential.

What are the different types of Index Funds?

Index funds are investment vehicles that track the performance of a specific market index, such as the S&P 500 or the Russell 3000. These funds have become increasingly popular due to their low costs, diversification, and ease of use. Below are eight types of index funds and their pros and cons.

1. International index funds 

International index funds invest in stocks and other securities from countries outside the investor’s home country. They provide diversification by spreading investments across various countries and economies. Pros of international index funds include exposure to potential growth in emerging markets and diversification across different countries and economies. Currency risk due to fluctuations in exchange rates and geopolitical risks are potential cons. Examples of international index funds include the Vanguard Total International Stock Index Fund and the iShares MSCI ACWI ex U.S. ETF.

2. Equal-weight index funds 

Equal-weight index funds allocate an equal percentage of the fund’s assets to each stock in the index, regardless of the company’s market capitalization. Pros of equal-weight index funds include reducing concentration risk by not overexposing the fund to the largest companies and the potential to outperform cap-weighted funds in certain market conditions. But higher turnover and transaction costs due to frequent rebalancing and the possibility of underperforming cap-weighted funds in some market conditions are potential cons. Examples of equal-weight index funds include the Invesco S&P 500 Equal Weight ETF and the WisdomTree U.S. MidCap Dividend Fund.

3. Broad market index funds

Broad market index funds aim to track the performance of a broad market index, such as the S&P 500 or the Russell 3000 They provide investors with exposure to a large segment of the market. Pros of broad market index funds include diversification across a wide range of stocks and low cost and tax efficiency. Limited exposure to specific sectors, industries, or themes and the possibility of underperforming compared to more concentrated or specialized funds are potential cons. Examples of broad market index funds include the Vanguard Total Stock Market Index Fund and the iShares Russell 3000 ETF.

4. Custom index funds 

Custom index funds are designed to track a specific, tailor-made index created by the fund provider or a third party. These indexes focus on certain themes, sectors, or investment strategies. Pros of custom index funds include the ability to target specific investment themes or strategies and offering more flexibility and customization for investors. But they can be more expensive due to higher management fees and have lower liquidity compared to more popular indexes. Examples of custom index funds include the Global X Millennials Thematic ETF and the Invesco Solar ETF.

5. Market capitalization index funds

Market capitalization index funds track indexes that are weighted by the market capitalization of the constituent companies, meaning larger companies have a greater influence on the index’s performance. Pros of market capitalization index funds include low cost and tax efficiency and exposure to the largest and most established companies. Concentration risk due to overexposure to the largest companies and the possibility of underperforming in certain market conditions are potential cons. Examples of market capitalization index funds include the Vanguard S&P 500 Index Fund and the iShares Core S&P Mid-Cap ETF.

6. Factor-Based Or Smart Beta Index Funds

Factor-based or smart beta index funds aim to outperform traditional market-cap-weighted indexes by targeting specific factors, such as value, growth, momentum, or quality. Pros of factor-based or smart beta index funds include the potential for outperformance over traditional index funds and exposure to specific factors that drive returns. Higher management fees compared to traditional index funds and the possibility of underperforming in certain market conditions are potential cons. Examples of factor-based or smart beta index funds include the iShares Edge MSCI USA Momentum Factor ETF and the Invesco S&P 500 Low Volatility ETF.

7. Sector-based index funds

Sector-based index funds focus on specific sectors of the economy, such as technology, healthcare, or financials, providing targeted exposure to a particular industry. Pros of sector-based index funds include targeted exposure to specific industries or sectors and the ability to be used for tactical asset allocation. Higher concentration risk compared to broad market index funds and the possibility of underperforming the broader market in certain conditions are potential cons. Examples of sector-based index funds include the Technology Select Sector SPDR Fund and the Vanguard Health Care ETF.

8. Debt index funds

Debt index funds invest in a diversified portfolio of fixed-income securities, such as government bonds, corporate bonds, or municipal bonds, aiming to track a specific bond index. Pros of debt index funds include providing income and diversification for investors and lower risk compared to equity index funds. They have lower returns compared to equity index funds and exposure to interest rate risk. Examples of debt index funds include the iShares Core U.S. Aggregate Bond ETF and the Vanguard Total Bond Market Index Fund.

Choosing an index fund becomes a chore given the amount of choice it provides. The key is to understand your risk appetite and goals and choose a fund that matches the same. 

How to invest in an Index Fund?

Index Fund Investing can be done easily; here’s how.  

Investing is an easy and cost-effective way of diversifying your portfolio while giving exposure to a wide array of stocks or bonds. Below is an outline of how to invest in index funds:

1. Research Index Funds

Start by conducting some initial research on various index funds and their underlying indices, considering factors like performance history, expense ratio and investment strategy of each fund. 

2. Select an Investment Platform

Identify an appropriate brokerage or investment platform with commission-free trading, low account minimums and access to an array of tools and resources for investing.

3. Open a Brokerage Account

Create an account with your chosen investment platform. This step typically includes providing personal details such as name, address, identity and employment data as well as answering any necessary questions regarding investment experience or risk tolerance.

4. Fund your Account

You should fund your brokerage account via bank transfer, UPI, or even cheque. Funds become available for trading within 24 hours to 48 hours of their arrival in your brokerage account.

5. Place Your Order 

Navigate to your trading platform and search for an index fund using its ticker symbol. Select how many shares you would like to buy and select your order type: market orders will execute at the current market price while limit orders allow you to specify an exact price at which to buy an index fund.

6. Monitor Your Investment

Make it a habit of reviewing the performance of your index fund on an ongoing basis and consider rebalancing as needed. Index funds investors still essential to remain vigilant of how things are progressing and adjust accordingly as necessary.

Investing in index funds is a straightforward and cost-effective way to build an investment portfolio with long-term potential. Follow the above steps to get your investing journey started.

What are the best Index Funds to invest in?

It is impossible to gauge which is the best index fund as what is considered ‘best’ depends on personal preferences including investment goals. Below is a list of five index funds nevertheless. 

• Nippon India Index Fund Nifty 50
• HDFC Index Fund Nifty 50
• UTI Nifty 50 Index Fund
• ICICI Prudential Nifty 50 Index Fund
• SBI Nifty Index Fund

These funds track the Nifty 50 index, which is a basket of the 50 largest companies listed on the National Stock Exchange of India. 

What are the benefits of Index Funds?

Index funds come with five main advantages. Those are listed below.

1. Diversification

Index funds provide access to a diverse group of stocks or bonds within one market index, giving investors the ability to diversify their portfolios by lessening the impact of underperforming securities in individual positions.

2. Low-Cost

Index funds tend to offer significant cost savings over the long run due to their passive investment strategy and typically have lower expense ratios compared with actively managed funds. This could add up to significant cost reduction over time.

3. Easy access to stocks

Index funds provide an efficient and straightforward method to gain exposure to certain markets or sectors without needing to research and select individual stocks or bonds.

4. Better returns

History has demonstrated that most actively managed funds underperform their benchmarks over the long term, making index funds an attractive option for investors who achieve better returns by simply following their performance.

5. Accessibility 

Index funds are accessible to investors of all stripes, from individual retail investors to large institutional funds. A variety of index funds are available that cover diverse asset classes, sectors and geographical regions to make finding one suitable to one’s investment goals straightforward.

These advantages make index funds a good option for both conservative and aggressive investors, especially if invested right and according to one’s risk appetite and goals.

What are the risks in investing in an Index Fund?

The disadvantages of index funds mostly root from the risk of investing in them. Below are the six main risks.

1. Market risk

Index funds that track specific market indices are exposed to the fluctuations and volatility of the market, meaning if its performance declines it could suffer losses too.

2. Index Funds Lack Active Management

Index funds do not attempt to outstrip the market or identify undervalued securities. This is an advantage for some investors but for investors who opt for index funds do not benefit from superior returns generated by skilled active managers.

3. Concentration Risk

Some indices contain too many concentrations in specific sectors or companies, which increases the risk of poor performance if those sectors or companies underperform. This lack of diversification within an index fund increases its exposure.

4. Tracking Error

Index funds attempt to replicate the performance of their underlying index perfectly, but tracking errors still occur due to factors like fund expenses, transaction costs and differences in composition between their fund and that of the index.

5. Liquidity Risk

Index funds that follow lesser-known or niche indices experience reduced trading activity and less liquidity than expected, leading to more comprehensive bid/ask spreads and potentially increased trading costs for investors.

6. Currency Risk

Investors in international index funds are exposed to fluctuations in currency exchange rates that adversely impact the value of an investment, sometimes even when its underlying securities perform well. These fluctuations impact an investor’s returns significantly.

Understanding the below risks will help investors strategies and stay away from losses caused by the same.

What are examples of Index Funds?

Below are top examples of Index Funds in India categorized by the index they track.

• S&P BSE Sensex Index Funds

Nippon India Index S&P BSE Sensex Fund

HDFC Index S&P BSE Sensex Fund

UTI Sensex Fund

• Nifty 50 Index Funds

ICICI Prudential Nifty Index Fund

Aditya Birla Sun Life Nifty 50 ETF

Kotak Nifty 50 Index Fund

• Nifty Midcap Index Funds

HDFC Mid-Cap Opportunities Fund

Aditya Birla Sun Life Midcap Fund

Nippon India ETF Nifty Midcap 100

• Nifty Smallcap Index Funds

Reliance ETF Junior BeES

SBI Small Cap Fund

Franklin India Smaller Companies Fund

• Global Index Funds

ICICI Prudential Global Stable Equity Fund

Motilal Oswal Nasdaq 100 ETF

Edelweiss Greater China Equity Off-shore Fund

• Sectoral Index Funds

ICICI Prudential Technology Fund

What are the hidden charges and costs for Index Fund?

Charges and costs associated with index funds include expense ratio, trading cost, exit load and tracking error – these terms cover everything from operating costs deducted annually from assets of an index fund through broker fees when buying/selling shares; fees charged when exiting early from the said fund as well as index tracking error which measures deviation between returns of an index fund vs returns of the index it tracks (the latter also called tracking error).

There are a few tips you should keep in mind to offset the costs. Choose index funds with low expense ratios so they will have less of an effect on your returns over time. Also, be wary of funds with exit loads if selling within a few years as their fees can eat away at your gains.

Long-term investing is also advised as doing so reduces the impact of hidden charges and costs on returns. Rebalancing portfolios regularly will also keep costs under control while controlling your risk exposure.

What is the S&P 500 index fund?

An S&P 500 index fund is a type of mutual fund or exchange-traded fund (ETF) designed to track the performance of the S&P 500 index. This index measures performance from 500 of the largest publicly traded companies in America. S&P 500 index funds are an attractive choice for investors seeking to track the performance of the stock market without picking individual stocks. They are low-cost and risky investment options that provide comprehensive market tracking capabilities. S&P 500 index funds have historically outshone actively managed funds over time due to their lower cost and greater likelihood of underperforming the market. Below are the top 50 constituents of the S&P 500 index as of  19, 2023, in order of weight.

• Apple (AAPL)
• Microsoft (MSFT)
• Amazon (AMZN)
• Tesla (TSLA)
• Berkshire Hathaway (BRK.A)
• Alphabet Class A (GOOGL)
• Johnson & Johnson (JNJ)
• UnitedHealth Group (UNH)
• Visa (V)
• JPMorgan Chase (JPM)
• Meta (META)
• Walmart (WMT)
• Exxon Mobil (XOM)
• Chevron (CVX)
• Berkshire Hathaway (BRK.B)
• Procter & Gamble (PG)
• Goldman Sachs (GS)
• Home Depot (HD)
• AbbVie (ABBV)
• AT&T (T)
• The Walt Disney Company (DIS)
• Visa (V)
• Mastercard (MA)
• Johnson & Johnson (JNJ)
• Pfizer (PFE)
• UnitedHealth Group (UNH)
• Salesforce (CRM)
• Chevron (CVX)
• Cisco Systems (CSCO)
• Intel (INTC)
• The Home Depot (HD)
• Merck & Co. (MRK)
• AbbVie (ABBV)
• Travelers (TRV)
• State Street (STT)
• American Express (AXP)
• Verizon (VZ)
• ConocoPhillips (COP)
• Walgreens Boots Alliance (WBA)
• AbbVie (ABBV)
• AbbVie (ABBV)
• IBM (IBM)
• Procter & Gamble (PG)
• Travelers (TRV)
• Mastercard (MA)
• Goldman Sachs (GS)
• Johnson & Johnson (JNJ)
• UnitedHealth Group (UNH)
• The Home Depot (HD)
• Visa (V)

Are Actively Managed Funds better than Index Funds?

Both types of funds have their own set of benefits and drawbacks, ultimately coming down to each investor’s goals, risk tolerance and investment philosophy. Actively managed funds are managed by professional portfolio managers who use their experience and knowledge to select individual stocks or bonds they believe will outperform the market. Actively managed funds generally charge higher fees than index funds due to manager compensation requirements, but their potential advantage lies in being able to identify undervalued or overlooked securities with greater returns than would otherwise be achieved through market index funds. Index funds offer low fees and turnover compared to actively managed funds, providing broad market exposure with lower expenses. Research has even indicated they outshine actively managed funds over the long haul.

Whether actively managed funds or index funds are better for an individual hence depending on their investment goals and risk tolerance. Individuals willing to pay higher fees in return for potential outperformance prefer actively managed funds. Those prioritizing low fees and broad market exposure prefer index funds. It’s essential that investors conduct their own research as well as consult a financial advisor in order to select one that aligns best with their specific strategy and goals.

Are Index Funds the same as ETFs?

No, Index funds and ETFs (Exchange-Traded Funds) share many similarities but there are distinct distinctions between them that could sway investors one way or the other.  

An index fund is a type of mutual fund that invests in securities designed to match the performance of an index. They typically trade once per day after market close, and investors purchase and sell directly with the fund company. Index funds often feature low expense ratios and offer cost-effective exposure to broad markets and many consider them cost-effective means for broad market exposure. ETFs are similar to index funds in that they track an index but trade on an exchange like stocks. This means investors can buy and sell ETFs throughout the day at market prices just like individual stocks would. ETFs also typically boast lower expense ratios while providing flexibility and liquidity to investors.

One of the primary differences between index funds and ETFs lies in how they’re traded and priced: index funds are priced daily while ETFs can be purchased or sold throughout the trading day at market prices, giving investors potential opportunities to acquire them at different prices than what would represent its net asset value (NAV).

Are Index Funds traded in the Stock Market?

No, Index funds do not typically trade on the stock exchange but are purchased and sold directly with their fund companies. They are purchasing part of their underlying portfolio which mimics stock market index performance when they purchase an index fund unit.

Are Index Funds Safe?

Yes, index funds are generally considered safe. It is because they provide long-term investors with diversified portfolios with a relatively safe investment option, due to their design as index funds emulating market indices. This encompasses various companies from various sectors and industry groups. This helps investors gain exposure to a diversified pool of stocks or bonds which helps reduce risk. Index funds also tend to have lower fees and turnover compared with actively managed funds, making them a more cost-efficient tax choice over the long haul.

But, investors should keep in mind that no investment is entirely risk-free and investing in index funds pose some additional risks. Its holdings could decrease in value, leading to losses for investors if an index fund tracks a market index that experiences a significant downturn.

What is the difference between Index funds and Index stocks?

An index fund and index stocks are related concepts in the world of investing, but they have some key differences. Below is a comparison of index funds and index stocks.

What is the difference between Index Fund and Mutual Fund?

An index fund is basically a category of mutual funds. Below is a comprehensive comparison. 

Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.