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Index funds are a type of mutual fund with a portfolio constructed to match or track the apparatus of a market index, such as the Standard & Poor’s 500 Index (S&P 500), BSE Sensex, or the NSE 50 (NIFTY). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.

An Index Fund holds all of the securities in the index, in the same proportions as the index. For Example, if there is an Index Fund replicating the BSE Sensex; it will invest in all those 30 securities that make the Sensex. Its feat is then expected to mirror the Sensex and the NAV will amplify when Sensex rises and vice versa. Other schemes include statistically sampling the market and holding “representative” securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities are purchased or sold and is therefore a form of passive management.

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What are Index Funds Economists cite the efficient-market hypothesis (EMH) as the fundamental principle that justifies the creation of the index funds. The hypothesis implies that fund managers and stock analysts are continually looking for securities that may out-perform the market; and that this competition is so effective that any new information about the fate of a company will quickly be incorporated into stock prices. It is postulated therefore that it is very tricky to tell ahead of time which stocks will out-perform the market. By creating an index fund that mirrors the whole market the inefficiencies of stock assortment are avoided.

Synthetic indexing is a modern technique of using a combination of equity index futures contracts and investments in low risk bonds to copy the performance of a similar overall investment in the equities making up the index. The bond portion can hold higher compliant instruments, with a trade-off of corresponding higher risk, a method referred to as improved indexing.

The advantages of Index Funds are given below:

• Low Costs – Because the composition of a target index is a known quantity, it costs less to run an index fund.

• Simplicity – The investment objectives of index funds are easy to understand.

• Lower Turnover – Because index funds are passive investments, the turnovers are lower than actively managed funds.

• No style Drift leading to accurate portfolio diversification.

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