Index Funds An Overview


Nidhi Srivastava
Lecturer (Finance)
Institute of Technology & Science

Investment markets are very complex. To build a portfolio of securities that consistently outperforms all other portfolios is virtually impossible. However, most portfolios do under-perform the indexes used to "measure the market." Since index funds own the stocks that make-up the index, they will perform as well as the market that the index measures. Index funds are perfect for the buy-and-hold investor - the kind of person who likes to sit back and let their investment grow, rather than moving in and out of the market in an effort to beat the market. An investor wishing his or her investment portfolio to keep pace with the market should consider index funds. Simply put, these funds are made up of the securities that comprise major market indexes. They do not try to beat the market. Instead, they try to match it.

How Index Funds Are Structured

An index fund that tries to match an index would hold the same securities that are in that index. The fund may weight the number of shares for each company it owns in proportion to the share price or company capitalization. For example, it may buy more shares of a company whose share price is lower than one with a higher share price. Alternatively, it may buy more shares of a large company than of a small company regardless of share price. The fund's prospectus describes the method of allocation. The fund may try to mimic the formula used in the index itself to achieve the same results as the index.

The first index fund for institutional investors was started in 1971 by Wells Fargo Investment advisors (Now Barclays Global investors) in San Francisco. The first such fund for retail investors Vanguard index trust was launched 5 years later. Indian Index mutual funds are invested in NSE Nifty or BSE Sensex companies in same weightage ratio as Sensex. Qualification criteria of companies for NSE Nifty or BSE Sensex are market capitalization and liquidity. Top 5 constituents of NSE nifty in weightage terms are Reliance, Hindustan lever, Wipro, Infosys tech, ITC.


Index Funds provide a perfect investment avenue for investors looking to invest into equity still not willing to take higher risks. This is because Index Funds propose to invest in companies in the same proportion as that of the underlying index. In this case the investor diversifies his risk due to other components prevailing in the market. An index fund is considered to be fully diversified as the component of unsystematic risk is minimized. The only risk that is left is the Market Risk, which cannot be diversified. With bear phase coming to end, it is time for retail investor to participate in stock market through Index Mutual funds.

Index funds require little to no active management. In most cases, computer-trading software dictates the portfolio allocation to match the chosen index. Buying and selling is infrequent because market indexes do not add or replace securities very often. As a result, portfolio turnover and management expenses are low.

The advantage of index funds is that they keep pace with the market. Their downside is that they cannot outperform the market. Some fund managers buy the top-performing stocks in the index instead of all the stocks in the index in an attempt to "beat the market." Such funds are not considered true index funds. Their competitive returns and lower management fees have made index funds popular for years.

Some of the Index Funds in India are as follows:

1. IDBI Index I-NIT'99, an index fund scheme on S&P CNX Nifty launched by IDBI - Principal Mutual Fund in July 1999.
2. UTI Nifty Fund launched by Unit Trust of India in March 2000.
3. Franklin India Index Fund launched by Franklin Templeton Mutual Fund in June 2000.
4. Franklin India Index Tax Fund launched by Franklin Templeton Mutual Fund in February 2001.
5. Magnum Index Fund launched by SBI Mutual Fund in December 2001.
6. IL&FS Index Fund launched by IL&FS Mutual Fund in February 2002.
7. Prudential ICICI Index Fund launched by Prudential ICICI Mutual Fund in February 2002.
8. HDFC Index Fund Nifty Plan launched by HDFC Mutual Fund in July 2002.
9. Birla Index Fund launched by Birla Sun Life Mutual Fund in September 2002.
10. LIC Index Fund Nifty Plan launched by LIC Mutual Fund in November 2002.
11. Tata Index Fund launched by Tata TD Waterhouse Mutual Fund in February 2003.
12. ING Vysya Nifty Plus Fund launched by ING Vysya Mutual Fund in January 2004.
13. Canindex Fund launched by Canbank Mutual Fund in September 2004.

Nidhi Srivastava
Lecturer (Finance)
Institute of Technology & Science

Source: E-mail November 17, 2005


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