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What are Index Funds, and How Do They Work?

Index funds: A simple, low-cost, and diversified way to invest in the stock market. Read ahead to know all about it.

  • Jul 20, 2023
Amit Raje
Written By :
Amit Raje

Amit Raje is an experienced marketer who has worked in various Fintechs and leading Financial companies in India. With focused experience in Digital, Amit has pioneered multiple digital commerce in India. Now, close to two decades later, he is the vice president and head of the D2C business department. He masters the skill of strategic management, also being certified in it from IIMA. He has challenged his challenges and contributed his efforts in this journey of digital transformation.

Amit Raje
Reviewed By :
Prasad Pimple

Prasad Pimple has a decade-long experience in the Life insurance sector and as EVP, Kotak Life heads Digital Business. He is responsible for developing user friendly product journeys, creating consumer awareness and helping consumers in identifying need for life insurance solutions. He has 20+ years of experience in creating and building business verticals across Insurance, Telecom and Banking sectors

Updated on: 29 June 2023

Investing is one of the most important tools to increase your wealth. With a number of options available in the market, index funds are attracting considerable investors. Index funds have revolutionized the field of investment by offering a powerful combination of simplicity, diversification, and cost-effectiveness. These funds are suitable for individuals with low or moderate risk appetites.

    Key Takeaways

  • Index funds are a kind of exchange-traded fund (ETF) or mutual fund that tracks a specific market index.
  • These are passively managed, which means that they do not try to beat the market but instead aim to match its performance.
  • These typically have lower fees than actively managed funds, which can lead to higher returns for investors over time.
  • Index funds provide a low-cost and diversified way of investing in the stock market.

In the field of investment, index funds have emerged as a popular choice for both novice and seasoned investors alike. They offer a simple and effective way to build a diversified portfolio while aiming to provide competitive returns. Index funds have lower management fees compared to actively managed funds, making them a widespread choice for cost-conscious investors.

This blog will help you understand what are index funds, how they operate, and how they are different from active investment options.

What is an Index Fund?

Index funds are financial instruments that follow a certain index or benchmark, such as the S&P 500. They fall under the category of passive index investing, which means that instead of being actively managed, their portfolios are created to reflect the performance of a specific index.

How do Index Funds Operate?

Index funds work by purchasing a portion of every stock in the index they are tracking. For example, if an index fund is tracking the S&P 500, it would purchase a small portion of each of the 500 companies in the index. This helps to diversify the portfolio, reducing the risk of index investing in a single stock. Additionally, the fund is managed passively, meaning that there is no need for a fund manager to make investment decisions, thus reducing the overall cost of management.

The performance of the best index funds is determined by the performance of the underlying index. This means that when the index goes up, the value of the index fund increases, and when the index goes down, the value of the fund decreases. The key idea behind these funds is to capture the overall market returns rather than trying to outperform them. This strategy is based on the belief that always beating the market over the long term is difficult and often requires significant expertise and resources.

Index Fund Returns

Index funds generally have lower fees than actively managed funds, which results in higher index fund returns for investors over time. This is because actively managed funds typically have higher management fees, which can eat into the index funds returns that investors receive. Additionally, index funds are designed to track the performance of a specific index, so their index funds returns are largely determined by the performance of the underlying index.

Index funds returns can be influenced by a variety of factors, including market conditions, interest rates, and economic growth. Historically, these funds have tended to outperform actively managed funds over the long term due to their lower fees and the fact that they are not actively managed. However, it’s important to keep in mind that past performance is not a guarantee of future returns.

Index Funds You Must Invest in

There are a wide variety of index funds to choose from, including funds that track domestic and international stock and bond markets. Some popular passive index funds to consider include

S&P 500 Index Fund

The S&P 500 index fund is a type of mutual fund or Exchange-Traded Fund (ETF) that tracks the performance of the S&P 500 Index. The S&P 500 index is a widely followed benchmark of the US stock market, representing the performance of 500 large companies listed on stock exchanges.

Total Stock Market Index Fund

A total stock market index fund is an investment fund that aims to duplicate the performance of a stock market index. The fund invests in a diverse range of stocks across different industries, market capitalizations, and geographies. This provides investors with broad exposure to the stock market. The objective of a total stock market index fund is to track the performance of the stock market as a whole, giving investors an easy way to invest in a diversified portfolio of stocks.

International Stock Market Index Fund

International stock market index funds are a type of investment that allows individuals to invest in a diversified portfolio of stocks from various countries around the world. These funds aim to copy the performance of a benchmark index, which tracks the performance of stocks from different countries and sectors.

Bond Index Fund

An international bond index fund is a type of mutual fund that invests in bonds issued by companies and governments worldwide. This type of investment provides exposure to a wide range of bond markets, allowing investors to benefit from a more diverse portfolio and potentially higher returns.

Comparing Index Funds and Active Managed Funds

Index funds aim to correspond to the performance of a specific index, offer low costs, and provide broad market exposure. Actively managed funds, on the other hand, seek to outperform the market through active investment decisions but typically come with higher costs and fees. The choice between the two depends on an investor’s preference for passive or active management, risk tolerance, investment goals, and beliefs about the efficiency of markets.

Let us compare the two on the basis of different parameters:


Index Funds

Actively Managed Funds

Investment Strategy

Index funds aim to repeat the performance of a precise market index, such as the S&P 500 or FTSE 100. They invest in the same securities as the index in the same proportions. The goal is to match the index’s returns.

Actively managed funds employ a team of professional fund managers who actively select and manage the fund’s investments. The goal is to outperform the market or achieve specific investment objectives.

Management Approach

These follow a passive investment strategy and have a rules-based approach. They have lower portfolio turnover and generally require minimal intervention.

These funds follow an active investment strategy. They aim to identify mispriced securities, capitalize on market opportunities, and adjust the portfolio’s holdings based on research and analysis.

Costs and Fees

These funds tend to have lower fee ratios compared to actively managed funds.

Since their strategy is passive and requires less research and trading, they have lower operating costs.

This results in lower fees for investors, allowing them to keep a larger portion of their investment returns.

These funds generally have higher expense ratios due to the additional costs associated with active management.

They require research, analysis, and trading activities, which can lead to elevated transaction costs and management fees.


They aim to imitate the performance of the underlying index.

They do not seek to outperform the market but rather deliver similar returns to the index.

These funds strive to outperform the market or achieve specific objectives.

Some actively managed funds may outperform their benchmarks, while others may underperform.

Risk and Diversification

These offer broad market exposure as they invest in a wide range of securities that make up the index.

This diversification helps lower the risk associated with respective stocks.

They are considered relatively low risk, especially when investing in well-diversified index funds.

The risk and diversification of actively managed funds depend on the specific investment decisions made by the fund managers.

Some active funds may have concentrated holdings, potentially leading to higher risk if those investments perform poorly.

Final Thought

As passive investments, index funds aim to imitate the performance of a particular or targeted index, providing investors with broad market exposure and stable returns. By avoiding the complexities and higher fees associated with actively managed funds, these funds have become a popular choice for both novice and seasoned investors.

With their simple and straightforward approach, index funds can provide an accessible and cost-effective way for individuals to index funds to invest in the stock market and build wealth over time.



Are There Any Fees for Index Funds?

Yes, index funds have fees, but they are generally much lower than those of competing products.


Index Funds: Are They a Good Investment?

Index funds are a good investment with low cost and the potential for long-term growth. They are suitable for investors who have a moderate or low-risk tolerance.


How can you invest in index funds?

There are a number of ways to invest in index funds. You can buy them directly from a mutual fund company or exchange-traded fund (ETF) provider, or you can buy them through a brokerage account.

In this policy, the investment risk in the investment portfolio is borne by the policyholder.

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