It is a type of fund that is designed to replicate the benchmark indexes which are S&P, DowJones, Sensex, Nifty etc. Most popular index fund is Standard & Poor 500 index which tracks 500 US listed companies from various industries. It can be done by selecting the same member securities which constitute the benchmark index and allocating the funds in same proportion as in the benchmark. An alternative approach is to reduce the sample size by selecting some important companies and allocating the proportionate amount to the representative sample as in the benchmark.
Suppose we want to index the S&P 500 by the index fund. We can track the Standard & Poor 500 by buying 500 stocks for our index fund in the same proportion as in the S&P 500 out of the total budget. The problem with this approach is higher transaction costs, poor portfolio management and not possible to buy the fractional amount of the securities to perfectly replicate the index.
Alternatively we can have five representative sectors and we can select total 50 stocks as sample to represent the S&P 500 index. For example 10 stocks per representative sample and we have to ensure that this representative sample replicates the same weights as in the benchmark as much as it can. The advantage in this approach is better management, low execution costs and low error to match the benchmark.
Active v/s Passive Management:
Passive Management is a strategy in which asset manager makes minimal decisions with respective to the portfolio allocations to reduce transactions costs. In the passive management, the weights of the securities are not changed at all and the objective of the manager is to exactly replicate the benchmark index in order to achieve same index return.
Active Management is a strategy in which asset manager makes portfolio allocations based on market volatility and return expectations with the objective to beat the benchmark index and get active return. To achieve this, the portfolio manager deviates from the target weightings to the securities as in the benchmark by buying securities which are expected to outperform the market index and selling or short selling the securities which are expected to underperform the market index. Tracking Error is the difference between the benchmark performance and index performance is known as tracking error.
Advantages of Index Funds:
Disadvantages of Index Funds
Difference between Exchange-Traded Fund and Index funds
Biggest difference between the exchange-traded fund and index funds is that exchange traded funds are redeemable to their NAV (Net Asset Value) even during trading hours whereas index funds takes days to redeem to NAV and also index funds disclose their NAV at the end of the day.