What are Index Funds?

Portfolio diversification across different financial products helps mitigate investment risks. You may invest in different asset classes, such as debt, equity, gold, real estate, and others. Furthermore, you may pick from different products within the various asset classes.

If you invest in equities, choosing shares of different companies with varying market capitalization and industries is a good way to diversify your portfolio. One of the available options includes index mutual funds. Wondering what are index funds? Read on to know more.

What are index funds?

These are mutual funds that invest the entire corpus to imitate the underlying index like the Sensex or the Nifty. These funds are passively managed and the fund managers invest in the same companies in a similar proportion that is included in the underlying index.

Therefore, your returns are in line with the benchmark index.

Introduction to stock exchange

Before proceeding on learning more about index funds, let us understand stock exchanges. India has multiple stock exchanges but the two most popular ones include the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE).

When companies are looking to expand their business, they go to these stock exchanges to raise money from the public.

Some companies may be large like Reliance Industries Limited while others may be smaller like Bata. You may choose companies from different sectors and compositions.

Stock exchanges have multiple categories to classify these companies to ensure investors are not confused. BSE includes the top 30 Indian companies in its S&P BSE Sensex 30.

A broader index is the S&P BSE Sensex 50 comprising the top 50 Indian companies. Other indexes include the S&P BSE MidCap, S&P BSE SmallCap, S&P BSE Capital Goods, S&P BSE Healthcare, and much more.

Similarly, there are various NSE indexes, such as the Nifty 50, Nifty 100, and others. You can visit the BSE and NSE websites to find a list of all these indexes.

How do index funds work?

While investing in these funds, you should choose from several options. Generally, most people invest in either the Nifty 50 index fund or the Sensex.

Fund managers copy the composition of the benchmark index to match its performance. However, there may be a small difference between the fund performance and index due to tracking error.

It is because the fund manager may not be able to buy and sell the stocks in the same proportion as comprised in the benchmark index.

How to invest in index funds?

Offline investing

You can visit the closest branch of the asset management company (AMC) along with the following documents:

• Know-your-customer (KYC) documents
• Identity proof
• Permanent Account Number (PAN) card copy
• Passport-sized photographs
• Canceled check

Investing through brokers

You can also invest in different funds like the Nifty MidCap Index or SmallCap Index schemes via a broker.

Online investing

You may invest online via a reliable portal that allows you to compare different funds. In addition to reducing your efforts, investing via an online portal eliminates commission or fees paid to the broker.

Once you evaluate different options, you may select the fund and estimate the future returns via an online calculator to make an informed decision.

Check out this article, to understand things to consider before investing in Index funds.

Who should invest in index funds?

• Investors with a longer investment horizon
• Those who do not want to constantly monitor and modify their mutual fund portfolio
• Individuals who have a low risk appetite but want to earn returns that are more than fixed-income products

Why should you invest in index funds?

Lower expense ratio

Schemes like the Nifty index funds are passively managed, which means they involve less research and the team required to make investment decisions is small.

Therefore, the total expense ratio (TER) is lower when compared to actively managed funds. An actively managed fund can have a TER between 1% and 2% percent whereas the TER of index schemes is between 0.2% and 0.5%.

Although this may seem a small difference, the actual effect on your long-term net returns could be significant.

Lesser efforts

Like most people, even you may not like the idea of selecting an active fund because it requires a lot of research.

Generally, you may invest in active funds based on their one-year performance and constantly change your portfolio based on this parameter.

As a result, you may end up with several mutual funds and earn returns similar to the index funds. Therefore, to save your time and efforts, putting money in index mutual funds is advisable.

Active funds vs. passive index funds

As the name suggests, active funds are actively managed by the fund managers. It means the fund managers and their teams conduct extensive research and decide on which stocks to buy and sell.

On the other hand, passive funds copy the stock composition of the underlying benchmark index, reducing the efforts of the fund managers.

Things to Consider Before Investing in Index Funds

Investing in index mutual funds may be less risky than large-cap funds. However, it is not completely risk-free. Before you invest in one of the several available options, here are four things to consider.

Time

To maximize your returns, it is recommended you invest in index funds for a longer period. It is advisable to hold your investment for at least five years to maximize the gains.

And if you hold the funds for seven years, it can be more beneficial. A longer holding period ensures your investment can tide through the short-term market volatility.

Since the recommended investment horizon is longer, you must not invest your contingency savings in these types of mutual funds.

Index category

There are several categories of index funds in India. Although there are a large number of indices on the stock exchange, index funds are available only for some of these.

So, if you choose funds like Tata Index Sensex Fund, LIC MF Index Sensex Fund, or Nippon India Index Fund – Sensex Plan, you are primarily investing in the top 30 companies in India.

Alternatively, if you want to invest in the top 50 Indian companies, you may choose funds that track the Nifty 50. Within this category, you can either opt for Nifty 50 Equal Weight or Nifty 50 Index.

The investee companies in both these types of funds are the same but there is still a minor difference. If you choose the Nifty 50 Index, some of the investee companies get more weightage while the others have a smaller weightage.

On the other hand, if you opt for Nifty 50 Equal Weightage, all the investee companies have the same weightage.

The concentrated portfolio of the Nifty 50 funds carries a slightly higher risk when compared to the equally distributed portfolio of the Nifty 50 Equal Weightage Index funds. You can make the decision based on your risk appetite.

Tracking error and expense ratio

Some of the best index funds have lower tracking error and expense ratios. Tracking error is primarily the deviation of the fund's performance when compared to the returns delivered by the underlying benchmark index.

This error arises because even though the fund managers try their best to mimic the index, there is some difference between the two. The expense ratio includes expenses like administrative costs and the lower the ratio, the higher will be your actual returns.

Compared to actively managed mutual funds, the expense ratio for index funds is lower. This is because the fund managers do not need to actively analyze various stocks and make investment decisions, which reduces the time and size of the research team.

Top-performing index funds in India

While analyzing the performance of funds, you need to consider several parameters. As of 7^th September 2021, the five top-performing index funds are listed below:

Frequently asked questions (FAQs)

Is investing in index funds risky?

All investments have some risk; however, investing in these funds for the long term ensures you mitigate the risks and earn stable returns.

Are there any fees while investing in index funds?

AMCs charge a small percent of the total value of your investment as an expense ratio; however, it is a minimal cost and varies across different funds.

Where can you buy index funds?

You can either buy these funds directly from the AMCs’ websites or via online portals. Alternatively, you may purchase these from the closest branch of the fund house.

What’s the difference between Index funds and ETFs?

Index funds are like mutual fund schemes wherein the fund managers mirror the holding based on the underlying benchmark. However, you can buy these funds only at their net asset value (NAV) determined at the end of the day. In comparison, exchange-traded funds (ETFs) are listed on the stock exchanges. Therefore, you can buy or sell these at any point during trading hours.

ETFs have a higher expense ratio due to trading costs like brokerage and Securities Transaction Tax (STT). Because index mutual funds are not traded and are passively managed, the expense ratio is comparatively lower than ETFs.

How are index funds taxed?

These funds are types of equity schemes and are taxed as other equity plans. The dividends are included in your income and taxed at your prevalent tax slab.

If you redeem the units within 12 months, the gains are considered as short-term capital gains (STCG)and taxed at 15% plus cess as applicable.

However, if your holding period is more than one year, the long-term capital gains (LTCG) up to INR 1 lakh are tax-exempt and profits exceeding this limit are taxed at 10% plus cess as applicable without indexation.