Index Funds and risks associated with them

Index Funds are passively managed Mutual Funds that simply copy a popular market index like the Sensex or Nifty. While Index Funds carry relatively lower market risk as compared to actively managed funds, the fund manager has limited ability to manage sharp corrections because the fund must hold all the securities in the index in the same proportion. He/she can’t buy more of an undervalued stock or sell an overvalued stock to take advantage of these market corrections. 

Since Index funds track specific market indices, they end up with a portfolio of established securities within a specific market segment be it large caps, small caps, multi caps, banking stocks, corporate bonds, etc. Thus, they limit the investor’s selection universe. 

In spite of mimicking a market index, these funds don’t provide the same return as the market index due to the presence of tracking error.  A market index doesn’t incur any cost when it undergoes a change in composition i.e when some security is added or removed from it. An index fund has to bear transaction cost to ensure its portfolio mirrors that of the index. Also, there could be a time lag when the stocks or weightage of individual stocks in an index undergo some change. This lowers the Index Fund’s return as compared to its Index return.