Index mutual funds diverge from investing in equities and instead focus on market indices. Hence, the simple answer to the question of 'what is an index mutual fund' is that these plans focus on mimicking the market index's performance. An index fund relies on equity, equity-related instruments and bonds to match the performance of the targeted indices.
Think of the market index as a standardised metric that tracks the performance of a basket of securities. Some funds invest in these indices to prevent the need for recognising opportunities in the market to divert investor funds. On the contrary, an index fund promotes passive investing. The goal is to make the fund match the performance of the index.
But why are index funds lucrative options for investors? Read on to find the answer and understand the calculations involved in an index fund.
In mutual funds, you can commonly find schemes that invest directly in equity or different sectors of the Indian economy. So, what's the primary difference between these and index funds? The former requires fund managers to actively track the market and invest at the right time to appreciate the value of the initial amount.
On the other hand, index funds aim to replicate the performance of their respective market indices. Since these benchmark indices do not change frequently, an index mutual fund maintains a uniform portfolio for extended periods.
The passive method of investing in index funds also enables them to operate at a lower cost. Dedicating no cost to special research analysts or constant transaction charges helps these schemes pose a minimal operating cost to the fund manager.
The market index increases or decreases based on the performance of the underlying stocks. It fluctuates throughout the trading day and reflects the market's overall situation.
The value of index funds depends on the underlying assets, i.e., the different equity instruments and governmental bonds. In summary, the calculation for an index fund comprises two elements – each stock's market value and the index's total market value.
For example, consider an index that has 30 underlying securities. The market value of each stock in this index is calculated using its price and the number of shares included in the index. Multiplying these figures will provide market value. Next, the weight of each stock in the index can be ascertained by comparing its market value against the total value of the index.
The securities in these indices affect their value. Since an index fund mutual fund largely resembles the indices, the investments appreciate or depreciate to the whims of the index. However, the most significant advantage is that these funds do not require active tracking and can be passively managed without incurring additional costs or resources.
Index mutual funds focus on replicating the performance of a market index by investing in a basket of securities, including equity. The primary advantage of index funds is that they eliminate the need for active tracking and reduce costs, making them a lucrative option for investors seeking a low-cost, passive investment strategy.
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Indexation is applied to debt mutual funds to account for inflation. It applies to debt mutual funds that have been held for over three years. You can decrease capital gains and tax liability by applying indexation to your profits.
Indexation is limited to debt mutual funds and only applies to realised capital gains.