How mutual funds are linked to stock market indices

Compared to investing in direct stocks, mutual funds offer a relatively more affordable and stable investment avenue for small investors. But do you ever wonder if the ups and downs in the stock market impact mutual funds as well? Just like you, many investors are curious about this link between stock market indices that represent broader market performance and mutual funds.

To enhance your knowledge, this article will simplify the connection between mutual funds and stock market indices, how the indices' performance affects mutual funds, along with the risks and benefits of investing in index based mutual funds.

• Table of contents

• Understanding stock market indices
• Mutual funds and market indices – the connection
• Types of mutual funds that track stock indices
• Active vs passive funds: Index funds and beyond
• How index performance affects mutual fund returns
• Risks and benefits of investing in index-linked mutual funds
• Market fluctuations and their impact on index-linked funds
• Choosing a suitable mutual fund based on stock market indices

Understanding stock market indices

The simplest definition of stock market indices or a stock market index is that it is a group of selected stocks used to represent a segment of the market. These stocks are chosen based on their size, sector or trading frequency.

Indices help track the performance of the overall market without the need for looking at each stock one by one. Some common stock market indices in India are Sensex, Nifty 50, Nifty Bank, Nifty Midcap, etc.

Mutual funds and market indices – the connection

It won’t be incorrect to say that when a mutual fund follows a stock market index, it tries to mirror its performance. Let’s say if the Nifty 50 goes up by 5%; then, the index fund tracking the Nifty 50 will aim to grow by a similar percentage. Thus, index funds are designed to track a particular index and replicate its performance.

Moreover, actively managed mutual funds where fund managers pick stocks based on their research with the aim of beating the market are often compared against their benchmark index for accurate performance evaluation.

Types of mutual funds that track stock indices

Broad market index funds

Broad market index funds aim to mirror the performance of large stock market indices like the Nifty 500. They offer sector-wide diversification and are suitable for long-term investors.

Debt index funds

Debt index funds are suitable for investors seeking exposure to fixed-income securities. These funds track the performance of indices made up of various debt instruments, thus offering a relatively stable option compared to equity index investing.

Sector index funds

These follow indices from specific sectors like banking, IT or pharma. They are great for investors who want to invest in a particular industry.

Equal weighted index funds

These follow indices such as NIFTY100 Equal Weight to avoid skewness in weighting and mitigate concentration risk.

Growth index mutual funds

These follow underlying indices like NIFTY Growth Sectors 15 targeting high growth potential companies.

Read Also: Mutual Funds vs Stocks: Differences and Which is Better?

Active vs passive funds: Index funds and beyond

Active funds

These funds are managed by a fund manager who tries to pick suitable stocks to outperform the market. These funds are flexible and can change their portfolio based on market trends or company performance. They usually have higher fees due to research and management costs.

Passive funds (Index funds)

These funds do not try to outperform the market. They simply follow a specific index and aim to replicate its returns. Since they don't need active management, they have lower costs and are less flexible.

How index performance affects mutual fund returns

When the stock market index performs well:

Index funds usually show positive returns. Active funds that invest in similar sectors or companies also benefit. Investor confidence increases, attracting more money into mutual funds.

When the index performs poorly:

Index funds mirror the loss. Active funds may perform better or worse depending on the manager’s decisions. Overall returns tend to go down for most mutual funds.

Read Also: Stock SIP vs Mutual Fund SIP: Key Differences and Which is Better?

Risks and benefits of investing in index-linked mutual funds

Benefits

• Low cost: Index funds have lower management fees.
• Simplicity: Easy to understand and invest in.
• Diversification: You get exposure to multiple stocks.
• Market returns: You don’t miss out on broader market growth.

Risks

• No outperformance: You won’t beat the market and only match it.
• Market-linked losses: If the index falls, your fund will fall too.
• No flexibility: The fund manager cannot make changes even if some stocks are underperforming.

Market fluctuations and their impact on index-linked funds

A variety of factors cause market swings in India, from political events, like elections and budget announcements, to global economic changes and shifts in investor mood. During periods of high volatility, such as after major announcements or global crises, the stocks in an index may either rise or fall sharply. Since index-linked funds are tied to the overall market, this can cause their value to change in line with those movements.

Therefore, while index funds offer diversification, which helps mitigate risk, they’re still affected by market fluctuations.

Choosing a suitable mutual fund based on stock market indices

Understand your goals

Know if you are investing for long-term wealth creation or short-term gains. Index funds are more suitable for long-term goals.

Understand risk tolerance

Understanding your risk tolerance is crucial. You must know if you can handle short-term volatility or not. Index funds are less risky than stocks but not risk-free.

Check the expense ratio

Lower cost means better returns over time. Although index funds are more cost efficient compared to actively managed funds, it still makes sense to choose a scheme with a lower expense ratio.

Review past performance

Past returns don’t guarantee future success but give you an idea. Look at a fund’s performance compared to the benchmark to get some insight into its potential.

Choose a suitable index

Nifty 50 or Sensex for stable growth. Midcap or small cap index funds for higher risk and higher returns. Making a suitable choice depends on balancing your goals, budget, and comfort with market ups and downs.

Conclusion

Mutual funds linked to stock market indices offer a convenient and low cost way to grow your money over time. These funds are designed to mirror the overall market's growth without investors having to do research and pick individual stocks. Whether you are a beginner or a seasoned investor, knowing the role of stock market indices––and the funds that track them––can help you build a more resilient portfolio.

FAQs:

How do stock market indices influence mutual fund performance?

Stock market indices act like a roadmap for many mutual funds. When the index rises or falls, funds that track or benchmark themselves against that index usually show similar movement. For example, if Nifty 50 rises, an index fund linked to Nifty 50 will likely also go up.

What is the difference between index funds and actively managed funds?

Index funds follow a specific market index and aim to match its performance. They don’t try to outperform the market. Actively managed funds are handled by expert managers who choose stocks to try and outperform the market.

Are index-linked mutual funds relatively stable than direct stock investments?

Yes, in most cases. Index-linked funds are more diversified and carry lower risk than investing in a single or few stocks. However, they still go up or down with the market, so they are not entirely risk-free.

How can I invest in mutual funds that track stock market indices?

You can invest in such funds through bank, broker, mutual fund platforms, apps or directly through fund house websites.

What happens to index funds when the stock market crashes?

When the stock market crashes, index funds also drop in value. Since they simply follow the index, they cannot entirely protect against losses, although their inherent diversification may cushion the impact.

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