How index funds work

I want to know whether index funds are allowed to trade in index values through intra-day trading. Please explain the business model of index funds and how they generate returns for their investors.
- Sushil Kumar Makharia

Index funds are open-ended mutual funds which invest money in the same weightage and companies that comprise the index. Funds can track indices like the Sensex or the Nifty.

These funds, in comparison to actively managed funds, have a lower risk-return profile. An index fund will not turn in that high returns as a diversified equity fund would when bulls are on a rampage. At the same time, this category will not be as severely hurt as the diversified equity category when stock markets tank. Also the returns will be predictable and come at a lower expense ratio.

However, investments in these passively managed funds give up on the possibility of beating the markets.

Regarding the intra-day trading, mutual funds buy and hold securities. They do not operate like day traders.

This article was originally published on May 30, 2013.