Mutual funds are among the most popular investment options. The mutual fund universe can be divided into different types and categories. The types of mutual funds include equity, debt, and hybrid. The categories of mutual funds are index funds and actively managed funds. Both are great investment options for certain types of investors. Read on to learn more about index funds and the various types of index funds.
Before exploring the different types of index funds, it’s important to understand what index funds are. Index funds are mutual funds that aim to replicate the performance of the underlying index. They invest in the same proportion as the index, which helps them accurately track the index’s performance. These passively managed funds are a great option for investors looking to diversify and invest in an effective, cost-efficient manner.
Index funds are mainly categorised into the following types:
The objective of broad market index funds is to replicate the performance of a broad stock market index, such as the S&P 500 or Nifty 500. These funds invest in several sectors, allowing investors to diversify and invest in the broader market. They are a suitable investment option for long-term investors.
A market capitalisation index fund is an index fund that invests in an index’s constituents based on their market capitalisation. Market capitalisation is calculated by multiplying the share price by the total number of outstanding shares.
Larger companies have a higher market capitalisation and are given more weightage in a market capitalisation index fund. Conversely, companies with a lower market capitalisation have a lower weight. Investors can diversify their portfolios by investing in funds that target large, mid, or small capitalisation companies.
An equal-weight index fund invests equally in all the index components. These funds give equal weightage to all the constituents of an index. As a result, the portfolio is balanced, and the risks of any overconcentration in a single company are reduced. Consequently, every company in the portfolio has an equal impact on the fund’s performance.
Factor-based or smart beta index funds are funds that invest in the constituents of an index based on specific factors, criteria, or investment strategies. Unlike focusing on market capitalisation, these funds focus on factors like value, momentum, growth, and quality. Depending on the factor, the funds allocate weight to the company. For example, a company that has a higher return on equity (RoE) might be given higher weightage in a factor-based index fund.
Smart beta index funds have been gaining significant traction lately as they aim to manage risk, returns, and volatility efficiently.
Strategy index funds are funds that strive to replicate the performance of a strategy index. For example, a fund may aim to replicate the performance of an index that tracks high dividend yield stocks or low volatility stocks. These indices can also include multiple asset classes like equity and debt.
Sector-based index funds are among the most popular types of index funds, as these funds track sectoral indices. For example, sectoral index funds may include funds that track banking stocks, infrastructure stocks, or technology stocks. These funds also provide a more narrowed-down approach with specific sectoral index funds like PSU banks or private banks.
Some investors have their eyes on getting international exposure and diversifying their investments overseas. Through international index funds, investors can capitalise on opportunities in the global markets. These funds track indices that comprise stocks, bonds, and various securities issued by companies and governments across the world.
Debt index funds are an ideal investment option for investors looking to invest in fixed-income securities. Debt index funds are funds that replicate the performance of indices consisting of various debt instruments. However, debt index funds are some of the less popular types of index funds in India due to associated risks. The two major risks of debt instruments are changes in interest rates, which impact bond prices, and the risk of defaulting when an issuer of a debt instrument fails to make a payment.
Custom index funds are another lesser-known type of index fund in India. These funds replicate the performance of customised indices to meet the requirements of institutional investors or major clients. These index funds provide greater flexibility and also align with the investment goals of a client.
Now that we’ve looked at the types of index funds, let’s understand some of the benefits of investing in them.
Just like most investment vehicles, index funds also have associated risks that an investor should be aware of:
Sectoral index funds or index funds that are highly concentrated in a particular sector may be impacted due to sectoral risks or market declines.