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Index funds were first introduced in United States in 1973. Index fund is a special type of mutual fund or exchange traded fund. The index funds are modeled after the popular indexes of the major stock exchanges. The index on which a specific index fund is modeled is termed as the target index for that specific index fund. The method that is used for managing the index funds is to track the index and invest in the same stocks that the target index is made of. Moreover, in index funds the stocks are chosen and invested in the same ratio that of the target index. This is how the fund mangers of the index funds aim to replicate the performance of the index.

Tracking for the index funds – Tracking is the method that is done to replicate the performance of the target index for the index fund. For tracking most of the funds these days use the computer programs to statistically sample the representative stocks of the target index. In this way the human emotions can be excluded from fund management. This is a method of passive management of the fund that eventually reduces the fund management cost.

Different indexing methods - There are so many methods of indexing that are followed by the index funds all around the world. Here we are presenting some of the most common forms of indexing.

Traditional indexing – It is the most conventional form of indexing that is being followed by the fund managers since the advent of the index funds. In this method the fund is constituted with same stocks in the same ratio that of the target index. In this type of funds the modification of the holdings is done according to the index that is when modification of the companies is done in the index.

Synthetic indexing – In synthetic indexing the earning of the fund is increased by investing in future contracts, low risk bonds along with the stocks that part of the target index. So in other words synthetic indexing is method that is more advanced but based on the traditional indexing method. This is a relatively modern concept in index fund management that has take up more aggressive stance to give better returns to the investors. But you have to also consider that maintaining the future contracts is more expensive than having the equities.

Enhanced indexing – Enhanced indexing method is used for ensuring optimum return for the funds. Apart from being a replica of the target index, different techniques are implied by the fund managers to maximize the return of the investors. For example, in this index funds customized indexes are followed instead of the commercial index. Fund managers also utilize different trading strategies, timing strategies and exclusion rules to ensure good return. But as these index funds are actively traded the fund management cost is higher than other type of index funds.

Operating indexing – In this method the performance of the stocks in the index is compared with other stocks in the index or the peer stocks to determine the formation of the index fund.

Advantages of Index Funds

• Index funds are believed to give you the best returns in the long run. This is because the indexes are made up of the most potential stocks in the market and as index funds replicate the index it surely have the optimum possibility to appreciate in the future.
• As the index funds are passively managed, it does not require the high fees of analysts and fund managers that results in lower fund management cost. Eventually this saving also adds up with the return from the fund.
• Index funds are modeled after the broad and popular indexes rather than the sectoral indexes. This means index funds have better diversification and less risk.

 

Disadvantages of Index funds

• Index funds can never outperform the target index in reality, whereas other mutual funds do have the chance of outperforming the index.
• If there is slight error in the indexing of the index fund by the fund managers, there is a chance of huge loss for that fund.
• In Indian context where the indexes themselves have limited stocks in their portfolio, the index funds that are modeled after them do have limited scope for diversification. So there is more risk with these funds.

 

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