A type of mutual fund with a portfolio constructed to match or track the components of a market index. An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover. An index fund is a mutual fund that aims to replicate the movements of an index of a specific financial market. An Index fund follows a passive investing strategy called indexing. It involves tracking an index say for example, the Sensex or the Nifty and builds a portfolio with the same stocks in the same proportions as the index. The fund makes no effort to beat the index and in fact it merely tries to earn the same return.
Index funds first came into being in the US in the 1970s. In the US the research established the efficient markets concept which says that stocks are mostly priced accurately and that it is not possible to beat the market in a systematic way. Though a few actively managed mutual funds may beat the market for a while, it is very rare for active funds to beat the market in the long run.
Advantages of Index Funds: As per efficient markets concept index funds provide optimum returns in the long run. An index fund doesn't have to pay for expensive analysts and frequent trading. Index funds track a broad index which is less volatile than specific stocks or sectors, thereby lessening the risk for investors.
In the Indian market scenario index funds may not be the best option. The basic principle of indexing is - the more the number of stocks comprising an index the better is the diversification and price discovery. Indian indices like the Sensex (30) and the Nifty (50) cover a relatively small number of stocks and ignore many opportunities in the mid-cap sector. Also, unlike the capital markets in developed countries, Indian markets haven't been thoroughly researched and there is enormous scope to beat the market by sound research.