Types of Index Funds: Strategies and Risks

An index fund is a mutual fund that replicates the portfolio of a particular market index. The funds are also known as index-tracked or index-tied mutual funds. As the name suggests, the performance of the scheme is in tandem with the benchmark index it tracks.

Five types of index funds

  1. Broad market index funds

This index fund attempts to imitate a large segment of the investible stock market. It enables investors to gain exposure to stocks across different sectors and market caps. For example, an index fund tracking the NIFTY 500 index is a broad market index fund. These funds capture the total performance of the stock market, and therefore, they are suitable for long-term investors.

If an individual invests in broad market index funds and other types of index funds, it will lead to overlapping in the holdings. It isn’t possible to avoid this overlap. However, by tracking the overall asset allocation across different market caps, you can ensure that the overlapping does not cause any bother.

  1. Market capitalization index funds

Many investors focus on size when they invest in index funds or mutual funds online. Indices are commonly weighted by market capitalization.

Stocks undergo fluctuations. As a result, every stock is either undervalued or overvalued at any specific time. A market cap index provides a lower weight to an undervalued stock and a higher weight to an overvalued stock. When an investor adds money to an index fund, this disparity increases even further. It leads to a disproportionate increase in the price of some stocks. However, when these overvalued stocks become unsuitably expensive, it causes a quick market-wide correction. Investors with a long-term horizon should not bother about short-term volatility with these index funds.

  1. Equal weight index funds

In an equal weight index, every stock carries the same weight. Let us take the NIFTY 50, for example, where the weight for all 50 companies is conceptually equal. Investing in an index of this type helps to counteract the over and under weighted-ness of indices.

In comparison to a market-weighted index, an equal weight index is more diversified. Investing in an equal weight index helps investors avoid the fluctuations caused by valuation biases and price momentum.

  1. Factor-based or smart beta index funds

Factor-based index funds have gained popularity recently. They are also known as smart beta funds and focus on attributes like cash flow, book value, dividend yield, PE ratio, sales, etc.

  1. Sector-based index funds

Sector-based funds are also popular investment options. Their objective is to invest in companies belonging to the same sector. When you opt to start a SIP, you will come across sector-based index funds ranging from healthcare, banking and infrastructure to technology and consumption, etc.

Summing up

Index funds help investors diversify their portfolios without spending on the purchase of individual securities or paying the high charges attached to actively managed mutual funds. They allow investors to gain additional exposure to certain asset classes, sectors, markets, and investment styles. Sign up with the Tata Capital Moneyfy App to be mutual fund investment-ready in minutes and start investing in index funds.

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