Index Funds are passively managed mutual funds, that intends to track the movements of a market index.
Being the cost effective investment option, these funds provides returns directly linked to index at a lower management cost. These funds invest in a securities/scrips similar to composition of index like Nifty or Sensex. However, the underlying security under the index fund may be a stock, bond, commodity, etc.
These fund provides returns similar to returns of index thus in order to track the market movements correctly, fund manager is required to hold all the securities in same composition and proportion as in the index. Since the fund manager of each index fund imitates the index, rather than trading securities separately in the market, thus it is also called as passively managed mutual funds because .
These funds allow you to invest in specific sectors and to invest in both growth and value stocks, giving you diversification with in sector or market.
While comparing the index funds, two things are required to be considered
Expense Ratio: Expense ratio is the management fee measured as a percentage of assets managed i.e. the lower the ratio the morecost effective is the fund is. Generally, Index funds have an expense ratio ranging between 0.75% and 1.5%.
Tracking Error: Tracking Error is calculated as the standard deviation fr the differene of returns among the benchmark and fund. Index funds must mimic market returns as both under-performance or out-performance as against the index is considered as a ‘tracking error’. The idea is always invest in an index fund with the minimum tracking error.
The optimal index fund is one which has lower expense ratio and low tracking error.