Index funds are a lesser known option of investment compared to mutual funds and stocks. Index fund investments are a form of passive investment while stocks and mutual funds offer a more direct approach. They are considered safe due to their affordability, higher long-term returns, diversification at a low cost, and lack of active fund management.

In this article, we will discuss the various types of index funds and their features.

Types of Index Funds

1. Broad Market Index Funds

Broad Market Index Funds consist of various stock options ranging from Large-Cap (Companies whose value is more than 50,000Cr) Companies, like ICICI Bank, Tata Steel, Reliance, etc to Micro-Cap (Companies whose value is less than 500 Cr) Companies like, Puravankara ltd, Nesco Ltd etc thereby ensuring that your investments are diversified across all sizes of the organization.

The ratio in which the money is bifurcated across these organizations provides stabilization from the Large-Cap Companies as well as growth from Micro-Cap Companies.

For example, the Motilal Oswal Nifty 500 is an index that includes various stocks from large cap to microcap companies.

Investing in broad market index funds may lead to overlapping holdings, but this is manageable as long as investments, asset allocation, and diversification are monitored.

So, to sum up, they are excellent for long-term investors as they look to capture the total performance of the stock market and do not focus on a particular size.

2. Market Capitalization Index Funds

Unlike broad market index funds, market capitalization index funds focus on companies of specific sizes (large, mid, or small) and are suitable for long-term investors with varying risk tolerance and growth potential preferences.

Types of Indices

They include indices like:

• NIFTY 50: Includes top 50 companies present in India.
• Sensex: A stock market index of 30 prominent companies on the Bombay Stock Exchange.
• NIFTY Midcap 150: Represents 150 mid-sized companies.
• NIFTY Smallcap 250: Represents 250 small-sized companies.

Weightage and Market Impact:

In these indices, larger companies have higher weightage, making higher-valued stocks more expensive. This can potentially cause market corrections if investors sell them quickly. However, for long-term investors, short-term ups and downs are usually not a big worry.

Example of Weightage:

The financial sector alone makes up about 40% of the Nifty 50's weightage.

3. Equal Weight Index Funds

Contrary to market capitalization index funds these funds have an equal amount invested in each stock. For instance, in the Nifty 50 equal weight fund, each company receives a 2% weightage.

Example of Weightage:

With each company at 2%, the top 20 finance companies account for only 22% of the weightage. This equal weightage offers good diversification, protecting portfolios by balancing performances of larger and smaller sectors.

Equal-weight indices offer greater diversification and can outperform market-cap weighted indices over the long term, especially if you prefer a value-oriented approach. However, they may underperform in bear markets or short-term periods as they include a lesser percentage of the stocks and also include smaller and less stable stocks. If you have a long-term investment horizon and value diversification, consider an equal-weight index.

4. Smart Beta Funds or Factor-Based Funds

These funds do not consider market capitalization but use metrics like PE ratio, dividend paying index funds, cash flow, and book value to categorize stocks.

They consider factors like:

• Value: stocks that show a lower price with respect to their actual value.
• Momentum: Stocks with stronger past performance
• Quality: Highly profitable stocks.
• Low volatility: Stocks that show minimum ups and downs.

There are two types of smart beta index funds which are single Factor funds, these types of index funds focus on single factor like quality and value, while the multi factor funds focus on a combination of two or more factors to manage returns, risk, and volatility more effectively.

Examples:

Edelweiss NIFTY 100 Quality 30: Basket of 30 high-quality stocks.

ICICI Prudential NIFTY Low Vol 30: Basket of 30 stocks with low price fluctuations.

So, in a nutshell, smart beta funds let you focus on specific investment factors like value or quality to match your goals. It's important to understand that while they offer many benefits, they also introduce risk and complexity because they use specific factors, which differ from traditional methods of building investment baskets.

5. Strategy Index Funds

The performance of strategy indices is mimicked by strategy index funds, using quantitative models and investment techniques to reach their objectives. Ex: NIFTY dynamic asset allocation.

Different ratios like P/e and P/b are taken into consideration for determination of baskets. If stocks are considered too expensive, the indices will allocate less money to stocks. On the flip side, if stocks are considered cheap, they will invest more in stocks.

This approach makes sense to investors who want to change their investment in stocks according to how the market values them at any given time.

The risks here are similar to that of smart beta funds as both of them do not use traditional methods of creating baskets.

6. Sector-Based Index Funds

These funds target specific sectors such as IT, Pharma, healthcare, or infrastructure. They are classified into narrow or broad categories.

Examples:

• Broad Categories: Technology, Healthcare
• Specific Categories: PSU Banks, Private Banks

If you understand the sector's dynamics and growth potential of these index funds before investing, the risk levels are none to negligible. Monitor market cycles as sectors can keep fluctuating.

7. International Index Funds

Indian investors are increasingly leaning towards international index funds to diversify and bridge the gaps in their portfolios. Major international indices include:

• NYSE FANG: Includes top traded companies like Facebook (Meta Platforms), Amazon, Apple, Netflix, Google (Alphabet), Alibaba, Baidu, NVIDIA, Tesla, and Twitter. They provide diversification as they have a low correlation with the Nifty 50.
• S&P 500: Covers 500 large U.S. companies. They include Vanguard 500 Index Fund, SPDR S&P 500 ETF, and iShares Core S&P 500 ETF.
• NASDAQ: Tracks the NASDAQ Composite or NASDAQ-100 indices, focusing on tech- heavy stocks. Examples include Invesco QQQ ETF.
• Hang Seng Index: Companies that rank high in China and Hong Kong are included here. Examples include the iShares Hang Seng Index ETF.

The global market fills many gaps to capture growth opportunities and reduce country-specific risk while Considering currency fluctuations and geopolitical factors it is important to invest in international funds as well.

8. Debt-Oriented Index Funds

Debt-based index funds are not commonly discussed among investors but are highly useful. Bond prices fluctuate frequently.

Two main risks to consider are:

• Interest Rate Risk: Bond values decrease as interest rates rise.
• Credit Risk: There’s a chance the issuer may default on payments.

Although not widespread in India, certain types, like target maturity index funds, help manage these risks. For example, the ICICI Prudential PSU Bond Plus SDL 40:60 Index Fund – September 2027 is a passive fund tracking an index of 8 AAA-rated PSU bonds and 20 State Development Loans in a 40-60 ratio.

They focus on interest rate trends and credit risk to ensure stable returns. It is the best for investors seeking regular income.

9. Custom Index Funds

A standard index fund usually follows the same common approach for everyone, however with research, technology advancement and improvement of data processing a customized strategy can be made.

Custom index funds allow institutions and advisors to design their own investment strategies within a passive framework. They allow them to customize and build their own blueprint.

Although not widely used yet, this approach is growing due to better technology and low trading fees. Indian mutual fund companies are also starting to adopt custom indices, and their popularity is expected to increase in the coming years.

Conclusion

Before investing, thoroughly research all the types of index funds including sustainable index funds and make a well-informed decision. In a nutshell, index funds help diversify your portfolio and provide long-term benefits through different Indian and international indices.Index funds offer passive, low-cost investment strategies with various opportunities of diversification.

FAQ’s

1. What is the Nifty 50 index fund?

A Nifty 50 index fund is a mutual fund that tracks the performance of the top 50 large companies from different sectors on India's NSE. It provides diversified exposure to these companies rather than investing in individual stocks.

2. What is smallcap index fund?

Small-cap index fund is a basket of funds that include smaller sized companies typically representing emerging or growth oriented firms. They offer potential for higher growth but with increased volatility compared to large-cap funds. Diversification is provided within the small-cap segment.

3. What is a midcap index fund?

Mid-cap index fund is a basket of funds that include medium-sized companies. They offer a balance of growth potential, stability, diversification and exposure to investors.

4. What is a growth index fund?

A growth fund is a diversified stock portfolio which targets capital appreciation with small to no dividends. It includes companies with above-average growth, reinvesting earnings into expansion or R&D, offering high potential returns but higher risk.