How to Invest in Stock Indices - Steps, Benefits, Key Factors

Last Updated: 13 Jan 2025

Is it possible to invest in stock indices? Stock index investment does not look practical since the closest you can get is to buy all the components of the index in the same proportion as the index. But there are smarter ways of stock index investment. For example, it is possible to buy an index fund that replicates. Another way of stock index investment is to buy an index ETF or exchange-traded fund that replicates the index. The third way of stock index investment is through derivatives like swaps, index options, and index futures.

The moral of the story is that, even though the index itself is abstract, there are methods of stock index investment by the use of proxies. Let us look at this in greater detail.

How to Invest in Indices?

What exactly is the definition of an index. You can look at an index as an imaginary portfolio of securities representing a particular market or a portion of it. For example, the Nifty is representative of all the large high-value stocks in the market. The NSE mid-cap index is a barometer of mid-sized companies on the NSE. The NSE auto index is a barometer of all the automobile-listed stocks on the NSE. The list can go on. The same logic applies globally too.

How to invest in indices? Is it possible to buy a stock index investment? While you cannot buy indexes, there are three methods or instruments you can leverage to replicate an index investment or mirror a stock index investment.

Firstly, you can just replicate the index

This is popularly known as indexing. Here, you effectively create your portfolio of securities that best represents an index, such as the Nifty or Sensex. The stocks and the weightings of your allocations would be the same as in the actual index. But this is a tedious and complex process and it is tough to buy the index as a basket at a single point in time. Hence you could see spillages resulting in a higher cost of purchase.

A very common method of index investing is a variant of indexing as above but it is called the Smart Beta approach. What exactly is this smart beta approach. It is essentially an attempt to amplify the returns of an underlying portfolio or index while minimizing tracking error. This is somewhere between being entirely active and entirely passive. Unlike basic indexing, smart beta tries to beat the index.

Index Futures and Options

This is a slightly trickier way of investing in an index and can be riskier than pure indexing or buying ETFs as we shall see later. If you are active in the F&O segment, you can buy index futures or index options. For example, in India, the Nifty futures and the Bank Nifty futures are extremely liquid and you can buy them as proxies for the index with a limited chance of error or spread the cost. You can also buy options of at the money or slightly out of the money strikes to replicate the index. This is an accepted strategy of indexing.

Index futures allow the trader to buy or sell a financial index today to be settled at a future date. Index futures can be effectively used to speculate on the direction of price movement for an index such as the Nifty or Sensex. But ideally, this is used to hedge index risk in the market or to hedge a portfolio of stocks. The other method is to buy index options and index options in India are extremely liquid. Index options are financial derivatives that give the contract holder the right, but not the obligation, to buy or sell the underlying index. All futures and options contracts come with expiry dates and are cash-settled only in India.

Index Mutual Funds

A very important method of buying the index is via index funds. Today most of the mutual funds in India offer index funds benchmarked on the Nifty or the Sensex. These are typically funds with low tracking error and mirror the index pretty well. The risk is low and costs are also low.

Exchange-Traded Funds or ETFs

Exchange-traded funds (ETFs) track an underlying asset and are split into tradable units and traded in real-time. Unlike index funds that only give day-end purchase and redemption prices, the ETF gives real-time buy and sell prices on the indices. ETFs are lower in cost scale than index funds also and can be used to replicate an index. Remember that both index funds and ETFs are designed to mimic the marketplace or a sector of the economy and require very little active management. At the same time, these index funds / ETFs also offer diversification at a much lower cost.

Differnet Instruments to Invest in Stock Indices

Investing in stock indices using a stock market app is called passive investing, and there are several instruments to facilitate such passive investments in the index. Here is a summary of the stock index investment instruments. Remember that passive management can be achieved through holding the following instruments or a combination of the following instruments.

1. First and foremost, you have the Index funds, which are nothing but mutual funds that try to replicate the returns of an index by purchasing all the securities underlying the specific index in the same proportion. Some funds even try to replicate index returns through sampling. Normally, a good index fund must track the index returns with a low tracking error
2. Secondly, there are the all-important and popular Exchange-traded funds or ETFs. These ETFs are open-ended, pooled, registered funds traded on a recognized stock exchange with a unique ISIN. Such ETFs can be held in your Demat account just like any other stock and represent proportionate unit ownership. There is a dedicated fund manager for the underlying portfolio of the ETF much like an index fund. These units of ETFs entail market making at the back-end.
3. Index futures contracts are a derivative bet on the movement in the price of a particular index. Stock market index futures offer investors multiple advantages. They offer easy trading, the ability to leverage through notional exposure, and zero management fees. However, futures contracts expire, so they must be rolled over periodically and this rollover has a cost implicit to it. Also, futures entail MTM margins regularly and the trader must be prepared for the same.
4. Alternatively, the trader can look at index options on particular indices. In India, the options on Nifty and Bank Nifty are extremely popular and also liquid. Options offer investors asymmetric payoffs in that they limit the risk of loss for the buyer but make it unlimited for the seller of the option.
5. Stock Market Index Swaps are yet to take off in India but are quite popular globally. They are normally over-the-counter or OTC contracts where you are allowed to swap a portfolio for an index or swap one index for another index or one market for another. The meaning of swap is an exchange.

Advantages of Investing in Stock Indices?

Let us now look at some of the major advantages or merits of investing using the index route.

• It is tough to beat the market and that has been proven time and again. Nearly 80% of the fund managers struggle to beat the markets in most of the developed markets and India is getting there. Indexing offers a much simpler and more reliable solution for such situations.
• Index investing helps to substantially reduce costs. Passive investing generally costs around 0.20% a year in fees, compared to around 1.75% percent for active investing. Over a longer time frame, this kind of cost-saving can make a huge difference to your returns on investment. This is more so in competitive markets.
• You don’t worry about churning your portfolio as that is done by the ETF or index fund. This minimizes your tax outgo. Also, you are always in sync with the index which is not possible if you index on your own. Unlike in active investing, there is pressure to beat the market, just to reduce the tracking error.
• Above all, passive or index investing is about discipline. Relying on the inherent strategy of an index fund puts an arm’s length distance between you and the trading decision. This makes your investment process more disciplined and dispassionate.

How Do Index Funds Work?

Index funds are mutual funds or ETFs that aim to mirror the returns of a particular stock market index like the Nifty 50. These funds invest in the same securities in the same proportions as the chosen index, and they provide diversified exposure to a segment of the market. Since they are passively managed, index funds have lower management fees than actively managed funds.

For investors, it means lower costs, simplicity, and long-term growth potential since most indices have been relatively upward over time. Since they simply mirror the index, index funds do away with the risk of picking individual stocks, allowing for almost perfectly correlated returns to the market itself.

How to Invest in Index Funds in India

Index funds have made investing super easy in India. Follow these steps:

• Understand Index Funds: Learn more about index funds and their advantages and disadvantages. Research commonly tracked indices such as Nifty 50 or Sensex.
• Set Investment Goals: Establish your financial objectives and risk tolerance. Determine whether you are interested in creating short-term or long-term wealth.
• Choose an Index Fund: Evaluate funds that track your preferred index. When choosing the best option, consider expense ratios, past performance , and tracking errors.
• Open an Investment Account: You must have a Demat and trading account with a broker or a mutual fund distributor. You can also invest directly via a fund house’s website or app.
• Complete KYC: Do your KYC using documents like PAN, Aadhaar, and Proof of Address.
• Start Investing: Decide whether to invest a lump sum or set up a Systematic Investment Plan (SIP). Place your order through your investment platform.
• Monitor Regularly: Periodically review the fund’s performance to ensure it aligns with your financial goals. Rebalance if needed.

 Benefits of Investing in Index Funds

Investing in index funds offers a hassle-free way to achieve market-aligned returns with lower costs and risks. Check out the advantages below:

• Low-Cost Investment: Index funds are passively managed, resulting in lower expense ratios than actively managed funds. This translates into low costs for a long-term investor.
• Diversification: Equity index funds are mutual funds or exchange-traded funds that invest in all the stocks of a particular index. They provide instant diversification across sectors and lessen risk from any individual stock’s performance.
• Market Returns: Unlike other funds, index funds try to mirror the performance of the benchmark index, so returns generally follow along with market growth. They remove the risk of bad stock-picking decisions.
• Simplicity: Index funds are easy to invest in because they do not involve researching or actively managing individual stocks. This makes them best suited for novices or passive investors.
• Consistent Performance: Indices usually reflect market trends, and with longer durations, most indices tend to trend positively and give stable returns to investors.
• Eliminates Bias: Index funds take a rules-based investment approach that helps to eliminate emotional or irrational decisions made with active management.
• Transparency: Holdings of index funds mirror the underlying index, providing complete clarity on where the investments are allocated.
• Liquidity: Since index funds are mutual funds or ETFs, they can be traded easily, meaning investors can purchase or sell units as they please.

Things Investors Should Consider Before Investing in Index Funds

Investing in index funds can be a wise strategy for wealth creation, but it’s essential to make informed decisions to maximize returns and minimize potential risks. Here are the key factors investors should consider before committing their money to index funds:

1. Understanding the Index

Index funds aim to replicate the performance of a specific index. Before investing, it’s crucial to understand the index being tracked, including its composition, sector allocation, and historical performance. Different indices cater to various market segments, so ensure the index aligns with your investment goals and risk tolerance.

2. Expense Ratio

While index funds generally have lower expense ratios than actively managed funds, costs still vary across funds. A lower expense ratio directly translates to higher net returns for the investor. Evaluate the fund’s expense ratio and compare it with similar funds to ensure cost efficiency.

3. Tracking Error

Tracking error measures how closely an index fund replicates the performance of its benchmark index. A high tracking error indicates inefficiencies in the fund’s management, leading to deviations from the index’s returns. Opt for funds with minimal tracking errors for better alignment with the index performance.

4. Investment Horizon

Index funds are best suited for long-term investments, as they tend to mirror market trends over time. Short-term market fluctuations can affect returns, but historical data shows indices generally grow over the long term. Assess your financial goals and ensure you have a suitable investment horizon before investing.

5. Risk Tolerance

Although index funds offer diversification, they are not completely risk-free. Their performance is directly linked to market movements, making them susceptible to economic downturns. Investors with low-risk tolerance may need to consider their ability to endure market volatility before committing to these funds.

6. Fund Performance and History

Evaluate the historical performance of the index fund. While past performance doesn’t guarantee future results, it can provide insights into the fund’s consistency and efficiency in tracking its benchmark. Also, consider the fund manager’s experience and the fund house’s reputation.

7. SIP vs. Lump Sum Investment

Decide whether to invest a lump sum amount or opt for a Systematic Investment Plan (SIP). SIPs allow you to invest regularly over time, mitigating the impact of market volatility and encouraging disciplined investing. Lump sum investments are better suited for investors with a higher risk appetite or specific financial goals.

8. Liquidity Needs

Consider your liquidity requirements before investing. While index funds are relatively liquid, redeeming units frequently may disrupt your long-term financial plans. Ensure you have other investments or savings for emergencies to avoid premature withdrawals.

Are Index Funds Good Investments?

Index funds are generally considered good investments, especially for those seeking long-term growth with minimal effort. They provide diversification by investing in all the stocks of a benchmark index, reducing the risk of individual stock volatility. With lower expense ratios compared to actively managed funds, they offer a cost-effective way to achieve market-aligned returns.

Additionally, index funds are transparent, easy to understand, and require minimal management. However, they are not immune to market downturns, as their performance mirrors the index. Overall, index funds are ideal for investors aiming for steady returns and a hands-off investment approach.

Are Index Funds Safer Than Stocks?

Index funds are considered safer than individual stocks due to their built-in diversification. By investing in an entire index, they spread risk across multiple companies and sectors, reducing the impact of any single stock’s poor performance. Stocks, on the other hand, are subject to company-specific risks, making them more volatile.

Index funds also eliminate the need for active stock selection, which can involve higher risks for inexperienced investors. However, index funds still carry market risks, as their performance is tied to the overall market. While not risk-free, index funds provide a more stable and less volatile option compared to individual stocks.

Frequently Asked Questions

Is a high face value good or bad?

A high face value isn’t inherently good or bad. It primarily represents the nominal value of a share and doesn’t directly impact its market price. Companies with higher face values may issue fewer shares, which can sometimes simplify calculations, but it doesn’t influence shareholder wealth directly.

What does 100% face value mean?

When a share is issued at 100% face value, the issue price matches the nominal or par value of the share. For example, if a share’s face value is ₹10, it is issued at ₹10 without any premium or discount. This is common for initial share issuances.

What is the difference between face value and issue price?

Face value is the nominal value of a share set by the company (e.g., ₹10). Issue price is the price at which the share is sold to investors. The issue price may include a premium above the face value, depending on market demand or the company’s valuation.

What is the minimum face value of a share?

The minimum face value of a share in India is typically ₹1 as per regulatory norms. However, companies can choose higher face values based on their preference or financial structure. The face value influences stock splits but doesn’t directly affect market value.

How is a share’s face value determined?

The company arbitrarily decides a share’s face value during incorporation. It is a nominal value used for accounting purposes and may not correlate with the company’s market valuation. The company’s board determines it based on its financial and equity structuring plans.