How Do Index Funds Operate And What Are They?

People generally opt for investing to earn extra income. The said extra income might be useful for the purpose of day-to-day expenditures. There are multiple options when it comes to choosing an investment scheme. You may consider signing up for investment options such as FDs (fixed deposits) or RDs (recurring deposits) that are offered by the banks. However, if you want to earn more on investment instead of depositing a portion of your income in a bank account, you could consider investing in the market. To invest in the market, you need to select an investment tool. One of the investment tools that you could use to allocate a portion of your income to mutual funds. They are investment tools in which an AMC i.e., asset management company collects money from a group of investors. Once enough money is pooled in the fund, it is used to purchase financial securities.

However, one of the important things to remember about mutual funds is that they are not a monolith and that there are different types of mutual funds available as an investment option in the market. One of these different variants of mutual fund schemes is index funds.

What are index funds?

An index fund is a variant of a mutual fund scheme that’s known for purchasing stocks similar to those found in a particular market index. It means that the index mutual fund scheme that you opted for will perform in tandem with the benchmark index it is tracking.

How do they work?

An index can be defined as a group of securities that are known to define a particular market segment. As index funds are known for tracking a particular index, they can be categorised under passive fund management. Under passively managed funds, the securities traded are known for depending on the underlying benchmark. Furthermore, passively managed funds are known for coming with a major advantage. They do not require a team of research analysts to identify opportunities and then pick the most-suited stock.

Are there any benefits associated with index funds?

Here are some of the advantages that are associated with investing in index mutual funds:

  • Index funds are known for being very affordable:

As mentioned above, under index funds, there is no need for a team of research analysts. Research analysts are the professionals that are known for helping fund managers in choosing the right stocks, i.e., those that are performing well. Also, in index funds, no active trading of stocks is involved. The above factors are known for resulting in things like the low managing cost of an index mutual fund scheme. In case you are seeking an option that doesn’t come with a huge fee, then, index funds might be an ideal option.

  • These funds are known for being easy to manage:

Another salient feature of index funds is that these mutual funds can be managed easily. That’s because the fund manager doesn’t need to worry about how the index stocks are performing in the market. All that’s required of a fund manager is to periodically rebalance the portfolio.

How are index funds and actively managed funds different from each other?

Listed below are the ways in which index funds and actively managed funds differ from one another:

Parameters Index funds Actively managed funds
Goal Index funds attempt to match the performance of a specific market benchmark or index Actively managed funds try to outperform the market benchmark
Risk Risks in index funds are directly linked to the benchmark’s risks Actively managed funds might come with additional risks when the fund underperforms its benchmark
Management fees Index funds enjoy low management fees as they follow their benchmark These funds require continuous professional management, resulting in higher management fees

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