An index fund is that type of mutual fund which is designed to be a copy of the index that it follows.
Index fund has it’s portfolio created to copy and follow the stock market index on which it is designed. For example, a Nifty Based Index fund, will have all the 50 shares of Nifty in same proportion as Nifty. And, thus it will follow the movement of Nifty.
The reason these types of funds are designed this way is to keep the operating costs low, have a good market exposure as well as eliminate the need of frequent changes in portfolio.
How does an Index Fund work?
When an index fund tracks a market index, for example Nifty, then it will have the portfolio of all the 50 stocks that are in Nifty.
So, the main job of fund manager here is to track the composition of Nifty (it is style for all the market indexes), and buy or sell the stocks based on the index.
In this process, there is no research team involved. Also because the no active decision making is being done by fund manager, index funds are also called as passive fund management.
Usually, when there is change in the composition of Nifty like any share being added/removed or percentage changes, the fund manager is able to make the adjustments in some time gap.
This leads to index fund performing either equal to or lower than index performance. This difference is called as tracking error.
The main job of fund manager here is to keep the tracking error as low as possible.
Do index funds pay dividends?
Index funds don’t pay dividends to the investors. Any money that the fund receives is reinvested back into the fund.
The reason for same is that, if fund pays out the dividend, then it will fall behind the index that it is following.
Rather the money is used to buy back the shares of the company which issued the dividend.
How to invest in index fund?
You can invest in index funds just like any other fund.
Pick you choice of mutual fund investing app, search the fund you want to invest into and there you go.
All you need to know is minimum amount to be invested and start your SIP.
Best index funds in Indian market
Though these funds are supposed to perform as good as Index they follow, but due to tracking error, there is indeed a slight difference in their performance.
Given below is the list of best performing index funds in Indian stock market based on their performance over last 1 year, 3 year and 5 year time frame.
All the performance are for direct investment route in these funds.
Read : Mutual Fund Expense Ratio – How it can effect your returns
~data source Valueresearchonline & ETMoney
| Name | 1 Year | 3 Year | 5 Year |
| HDFC Index Sensex Fund | 16.51% | 16.31% | 9.74% |
| Nippon India Index Fund – Sensex Plan | 16.3% | 16.18% | 9.33% |
| UTI Index Nifty Fund | 14.86% | 14.72% | 9.16% |
| HDFC Index Fund Nifty 50 Plan | 14.72%% | 14.71% | 9.18% |
| Tata Index Nifty Fund | 14.76% | 14.63% | 9.01% |
Final thoughts: Should you invest in Index funds?
In most cases Index funds perform equal or less than large cap mutual funds.
The reason is that the fund provides a exposure to wide market through top 50 stocks in stock market. These stocks are market leaders in their segment and thus they are likely to lead the growth in market.
Which means when overall large caps perform good, market index also shows the similar level of growth.
But, in reality, there are many more stocks which are large cap but not part of market index on which is fund is designed.
Thus, when you consider a large cap mutual fund by a good fund manager, you will get returns better than investing in index fund.
This difference is more clear when you include multi-cap funds, hybrid funds or even mid cap funds.
Because in all such funds, the skill of a good fund manager show bigger variations in overall returns of the fund.
And as we can see from this post, actively managed quality mutual funds perform a lot better than passive style index fund.
This observation is true only for non-thematic funds.
In case you are planning to invest in any thematic fund, then it is good idea to have a parallel investment in index fund to have a balanced portfolio of investments.