- What is an Index Fund?
- What is Benchmark Index?
- How Index Funds Work?
- Index Funds vs Actively Managed Mutual Funds
- Active Approach
- Passive Approach
But Exactly What is a Benchmark?A benchmark is a standard against which you measure your performance. Here are some daily life examples of benchmark:
- Your friend does 20 push-ups while you can manage only 10. Your gym instructor says, ‘seekho kuch isse’. This person is your benchmark!
- You decide to make your mom’s special Biryani. You follow the recipe exactly. While tasting, your dad says it needs a little bit of spice to be as yummy as your moms. Your mom’s Biryani is your benchmark.
- You score 80% in a math test while the topper scores 98%! He is your benchmark!
- If a mutual fund beats its benchmark, (outperformance) then it is a good fund.
- If a mutual fund does not beat its benchmark (underperformance), then it is a bad fund.
What is an Index Mutual Fund?As per the Securities and Exchange Board of India (SEBI), ‘An index fund is a mutual fund scheme which invests 95% of its assets in a particular index (which is being replicated/tracked)’. In India, majority of index funds are equity-oriented index funds. We do not have a debt oriented index fund yet. Every index fund has its own benchmark index. An index fund manager collects money from various investors. This collected money is then invested in exact same proportion as the benchmark index.
Types of Benchmark Indices
How Does an Index Mutual Fund Work?Suppose an index fund wants to invest Rs 100. Its benchmark is ABC Benchmark. ABC benchmark has the following allocations –
|TATA Steel Ltd||10%|
|Mahindra & Mahindra||20%|
|Reliance Industries||Rs 30|
|HDFC Bank||Rs 15|
|Infosys Ltd||Rs 25|
|TATA Steel Ltd||Rs 10|
|Mahindra & Mahindra||Rs 20|
- If you invest in a NIFTY 50 index, your fund manager will invest in the 50 stocks of NIFTY in the exact same proportion!
- If you invest in S&P BSE Sensex index, your fund manager will invest in 30 stocks of SENSEX in the exact same proportion!
Index Mutual Funds Vs Actively Managed Mutual Funds1. Fund Manager’s Control: The main difference between active mutual funds and index funds is the fund manager. In an actively managed mutual fund, the fund manager is in total control of the fund’s investments. He can decide which stocks to buy and which to avoid. This freedom is not available with an index fund manager. The below flow chart will help you understand the difference between an index fund and an actively managed fund.
How an Actively Managed Fund Works
How an Index Mutual Fund WorksAs you can see, an index fund manager does not research which stocks to buy or when to book profits.
- He will buy a particular stock when it is added to the benchmark index.
- He will sell a particular stock when it is removed from the benchmark index.
- The allocation of Reliance Industries in the benchmark index is 11.99%. TATA Index Sensex Fund maintains almost same allocation at 12.52%. But TATA Large cap fund reduces the allocation to 8.25%.
- The same thing is repeated for HDFC Bank. Its allocation in the benchmark index is 11.84%. Its allocation in index fund is 11.73%. But its allocation in large-cap fund is only 9.01%.
- The expense ratio of TATA Index Sensex Fund is 1%.
- The expense ratio of TATA Large Cap Fund is 2.43%.
- Tata Index Sensex Fund
- Tata Large cap Fund
- S&P BSE Sensex index
- ICICI Prudential Sensex ETF (Since TATA fund house does not have a Sensex ETF)