From an early age, we are taught to celebrate winners, look up to champions, reverie gold medalists. We make fun of participation trophies, when was the last time you heard somebody bragging about an average life or a perfectly average salary. We always measure our success by comparing it with others’ success.

So all in all with investments, how do you explain or compare the returns of investment? how do you know that how well or poorly your investments performed?

This brings us to benchmarking. An Index is that benchmark with which the performance of an investor can be compared. The investors always speak about alpha which is an investment strategy’s ability to beat the market in terms of returns. So the investors always compare their own returns to an index to measure this alpha we just discussed.

What is an Index?

An index is a hypothetical portfolio that represents a segment of a financial market. For example, the Nifty 50 Index, measures the average stock gains or losses of the 50 largest companies in India. There are indices virtually for every type of investment all across the world, be it precious metals, oils, bonds, etc. Their main use is as a comparison tool.

For a long time, trying to beat the index with your Mutual Fund made sense to most investors, who would want to put their money with a fund manager who charged expensive fees but failed to beat the market most of the time. Beating the market is not easy and not every fund manager could pull this through, as investment markets are random and complicated to be consistently predicted. This is where Index Funds were born, which provided a framework to pick stocks for investment, unlike Mutual Funds where the fund manager used to jump stock to stock to generate the alpha.

What is an Index Fund?

Index Funds are managed by financial institutions. From an investor’s perspective, it works in the same way as any mutual fund, it uses a passive investing strategy which means its objective is to deliver returns similar to an index of investments. Index funds include both Index Mutual Funds and Index Exchange Traded Funds. However, Index funds usually deliver returns that are slightly lower than the actual index due to fees associated with managing the funds, the fees are generally lower than Mutual Funds.

Some of the notable indices in India are as follows:

  • Benchmark indices like NSE Nifty and BSE Sensex.
  • Broad-based indices like Nifty 50 and BSE 100.
  • Indices based on market capitalization like the BSE Smallcap and BSE Midcap.
  • Sectoral indices like Nifty FMCG Index and CNX IT.

Each index consists of a group of companies and each company accounts for a fraction of the index. An Index Fund matches the exact components of any index and the investment is proportional and diversified.

Can Index Funds be actively managed?

Index funds are often known for the passive style of management. However, there are also actively managed index funds. The fund manager is involved in managing some aspects of the fund. For example, in a passively managed index fund, the manager invests proportionate to the index itself and doesn’t stray away from it; whereas, in an actively managed index fund, the manager chooses which companies to invest in from one or more indices. This requires careful calculation and consideration on the part of the manager, as well as his regular involvement over injecting or pulling back of funds.

Rebalancing the Indexes

Every once in a while, the institutions that publish these virtual indexes come up with some changes in the indexes. Reviewing or balancing Index funds is crucial, to match the index performance. There are no fixed timelines over when or how often this reviewing process must happen. Experts suggest that balancing must happen annually or sooner if the fund is very dynamic.

So…. What’s the best time to invest in Index funds?

While many prefer to follow the trends and patterns to buy. The optimal investment strategy is to go with a SIP based approach. For an individual investor, an Index Fund promises standard but stable returns, which is great for new investors and those with a low risk appetite. Index Funds are long-term investment opportunities with relatively lower investment expenses.

Returns to expect

Index Fund is somewhat considered a rookie’s game, or a safe player’s haven. The returns are standard, but its a safe long term bet. Think of it in market extremes – the best case scenario offers higher returns in the bracket, the worst case is a tracking error that lands to the same standard returns of the listed companies.

Some other types of Index funds in India

  • Nifty 50 Equal Weight – it is similar to nifty50 except it using a different weighing strategy. Rather than weighted average, it takes on equal weights for the absolute average.
  • Nifty Next 50 – it shows the companies ranked after 50, i.e. 51st to 100th as per free-float market capitalization.
  • Nifty Midcap 150 – It is the top 150 companies in NSE in mid-cap division. They are ranked 101-250 on the market.
  • Nifty Smallcap 250 – They are the 250 companies that make the smallcap market and are ranked 251-500 on the market.
  • Nifty 500 – It is NSE’s broad index made up of 500 companies that ranks companies over full market capitalization and categorizes them into Large Cap, Mid Cap and Small Cap on the basis of their rank.