To understand index funds it's useful to look at two different kinds of investment strategies for stocks.
The first is active investing. It means a determined effort to identify and purchase good stocks.
An active investor will carefully research an individual company, its financial statements, general business strategies and so on and try to determine the value of its stock compared to its current price.
If the stock of a company is undervalued (less than its actual worth) s/he will purchase the stock and continue to monitor the company's fundamentals. If and when s/he finds the stock price to be overvalued (more than its actual worth) s/he will sell the stock.
Obviously this involves a lot of effort in doing research and may involve significant costs when the investor buys and sells the shares regularly.
What is indexing?
A passive strategy, also known as indexing, is much less complicated and involves tracking an index like say the Sensex or the Nifty and building a portfolio with the same stocks in the same proportions as the index.
In other words there is no effort to beat the index: merely to earn the same return. This portfolio will passively track the two indices and reflect the corresponding change in them.
If these two indices increase in value your portfolio will follow suit. If their value drops so will your portfolio's worth.
An index fund is a mutual fund, which follows a passive indexing strategy instead of picking individual stocks.
Indexing may seem a strange strategy but there is a lot of research backing it up. The obvious advantage is that an index fund doesn't have to pay for expensive analysts and frequent trading.
Advantage of indexing
There is also a theory called the efficient markets hypothesis, which says that stocks are mostly priced (valued) accurately and that it is not possible to beat the market in a systematic way.
It's true that a few actively managed mutual funds may beat the market for a while but research, particularly in the US markets, has shown that it is very rare for active funds to beat the market in the long run.
Another advantage of index funds is that a broad index will be less volatile than specific stocks or sectors meaning that the investor faces less risk.
Origin of index funds
Index funds were first started in the US in the 1970's when the research that established the efficient markets concept began to trickle down to the finance industry.
There are about a thousand index funds in the US like the Vanguard 500, which tracks the S&P 500 index.
In recent years, index funds have been created in India as well like the FT India Index fund and HDFC Index Fund. Both these funds track the Nifty and the Sensex. (Stock mkt terms)
Index funds: Not the best option for India?
However despite their advantages, index funds may not be the best option in the Indian market today.
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.
An index fund that invests in just 30 or 50 stocks clearly doesn't offer a great deal of diversification. Contrast this with Vanguard 500 in the US, which tracks the changes in 500 stocks of the S&P 500 index.
The basic principle here is: the more the number of stocks comprising an index the better is the diversification and price discovery.
Unlike the capital markets in developed countries, Indian markets haven't been thoroughly researched which means that there may be more opportunities to beat the market by sound research.
Some also argue that the Indian stock markets are over-valued today after their spectacular growth in recent years (the benchmark Sensex has gained more than 100 per cent in the last five years), which means that a passive strategy may fare poorly in the next few years.
This is because the possibility of the Sensex-comprising 30 stocks to go down is higher compared to it making gains in the foreseeable future.
Finally, one of the biggest advantages of index funds: their very low expense ratios are less relevant to India where expenses are quite high.
Any mutual fund, be it an index fund or a gold exchange traded fund or an equity mutual fund, they need to spend money on marketing the project, pay the fund manager and other such expenses. These expenses as a percentage of total money collected to run the scheme is the expense ratio.
US index funds like the Fidelity Spartan 500 have expense ratios as low as 0.1 per cent, while Indian index funds have expense ratios as high as 1-1.5 per cent. This isn't that much lower than active funds like the HDFC equity fund with expense ratios of around 2 per cent.
Is it a potentially rewarding investment vehicle?
This does not mean that Indian investors should permanently ignore index funds.
Because in a few years many of their shortcomings in the Indian context may be resolved.
As capital markets mature and the quality of research increases, it will be harder to generate high returns through stock-picking and active strategies.
With increased competition, expense ratios in Indian index funds may fall making them more attractive relative to active funds. And while the markets may be overvalued today that will not be the case indefinitely.
Thus while index funds may not be the best investment vehicle today, they are a potentially rewarding investment that all savvy investors should understand.