What Are Index Funds?

Are you looking for a long term, less risky form of investment?

Index funds can be an ideal option.

If you are a first time investor with little knowledge about the meaning and operations of index funds, the following sections will provide you a comprehensive understanding of this investment instrument.

Stay tuned!

What Is Meant by Index Funds?

Index funds are a type of mutual funds that are passively managed by fund managers. Here, the investment copies the portfolio of specific indices index such as NSE 50 (Nifty) and BSE Sensitive index (SENSEX), popular indices in India. The asset allocation is similar to that of a particular index, meaning; the investment comprises all the shares a specific index contains in the same proportion.

Now that you know what is index mutual fund, we can move on to how do they work!

What Are the Different Types of Index Funds?

Read the table attentively and you will learn about different types of index Funds.

Types of Index Funds	Details
International Index Funds	International or Global funds offer investors an international exposure where they can buy funds that monitor specific indexes and are not restricted to any geographical region in the frontier market.
Broad Market	Funds belonging to this segment operate on a broad level and capture a wide range of markets. These types of funds have low expense ratios. Asset sales in this type passive mutual fund are small and tax-efficient. Investors looking for an investment instrument that holds a variety of shares and bonds can invest in Broad Market.
Bond Based Index Funds	This type of index funds investment can help investors in maintaining a perfect combination of short, intermediate and long term bond maturities and earn a steady income.
Market Capitalization	Investors who are willing to invest for the long term can benefit from heightened exposure to small and medium cap enterprises. Index funds can fulfil this objective on the basis of market capitalization.
Earnings Based	Index funds can function depending on the profits or earnings of a company. Here, two types of indexes are related to companies. These are growth index and value index. The Growth indexes refer to those where businesses can expect a return quickly than others in the market. On the other hand, value indexes comprise stocks that trade at reduced cost when compared to the earnings of a company.

How Do Index Funds Work?

When an investor invests in index funds, the fund manager utilises investors’ money to invest in stocks in the same manner as the index they are tracking. Here, fund managers do not play an active role in choosing industries or stocks to furnish the fund’s portfolio; instead, they follow the index and invest accordingly.

For instance, a NIFTY Index fund invests in stocks of various companies which holds the NIFTY 50 Index in the same way or proportion and will expect to get a return similar to that of the NIFTY 50 Index.

An example will clarify these roundabout sentences. Suppose, Reliance company has an 11.5% stake in the NIFTY 50. Therefore, the fund manager of the NIFTY 50 Index will create a portfolio giving a similar weightage of stocks meaning stocks of the company will be 11.5%. The same weightage will be given to other stocks of different companies.

Further, if a particular stocks weightage has gone up or down, fund managers will follow the same movement. Moreover, if stocks are sold and new stocks have been added, fund managers will replicate those actions as well and sell all the holding of stocks and purchase stocks following the same weightage in an index.

All these actions (buying and selling) are done passively; hence do not require a team.

As questions like what are index funds and how do they work; clear to you, we can now learn about the different types of index funds in detail.

Want to know about the benefits of investing in Index funds? Read along!

What Are the Benefits of Index Funds?

Low Expense Ratio: One of the major benefits of index funds is their lower cost. The costs of active funds are much higher than passive funds such as index funds. The asset allocation does not frequently change as it happens, so only when there is a change in the underlying asset allocation. Therefore, trading expenses are easy to keep on the lower side.
Steady Income: Stocks comprising index funds usually belong to well-established companies that are not easily affected by market fluctuations. It means investors can expect a steady and consistent return.
Automatic Clean Up: Portfolios of index funds enjoy an automatic clean up. The indices remove underperforming assets. Therefore, as an investor, you need not worry even if you have invested in an underperforming or slow performing asset as the index will do this job on your behalf.
Passive Fund Management: Since index funds do not require any active management, investors need not worry about the performance of certain bonds. Instead, they can focus on evaluating their portfolios from time to time.
Free of Security Risk: Index funds do not have security risks as the investment is made in a pool of various assets. Here, changes in some indices cannot practically damage the indices used.
Tax Benefits: The gains from index funds are taxable and primarily depend on two factors. These are,
- Holding period (the time you want to stay invested)
- Type of index fund chosen (equity or non-equity)

Almost all index funds barring Quantum Gold Fund are equity-oriented; they are subject to capital gain tax. Let’s learn about this in detail!

If investors sell units of equity-based index funds within 12 months, the gains will be termed as Short Term Capital Gains (STCG). On the other hand, if the holding period is more than 12 months, the gains will be considered long-term capital gains (LTCG).

The tax on short term capital gains is 15% (plus surcharge, if applicable and cess), and the tax on LTCG is 10% (plus surcharge, if applicable and cess) if the gains go beyond ₹ 1lakh.

For instance, if STCG is ₹75,000, investors must pay 15% of ₹75,000, which is ₹9000 as STCG tax. On the other hand, if LTCG is ₹4 lakh, you have to pay LTCG tax on ₹3 lakh (after the deduction) which will be ₹30,000 (10% of ₹3 lakh).

Returns from Index Funds

Follow the table mentioned below to get a clear idea about the returns from Index funds.

Index Fund	5 Year Return
Quant Active Fund Growth	25.16%
ICICI Prudential Smallcap Fund - Direct Plan- Growth	20.62%
ICICI Prudential Smallcap Fund	19.38%
DSP Flexi Cap Fund Direct Plan Growth	18.91%
SBI Contra Fund- Direct Plan- Growth	17.24%

Who Should Invest in Index Funds?

The investment decision of a mutual fund entirely depends on the risk tolerance and investment planning of investors. Index funds are an ideal choice for those who have a low-risk appetite and expect a steady return. Further, these funds do not demand thorough tracking. For instance, if you want to invest in equities but at the same time want to avoid the risk associated with actively managed funds, you can select NIFTY or SENSEX index funds.

The benefits of investing in index funds (mentioned earlier) seem promising, and now that you know about the ideal index funds, you can invest in them as per your suitability. However, there are certain factors that every investor must be aware of. Read along!

How to Invest in Index Funds in India?

There are wide ranges of indexes that investors can track using index funds. To invest in index funds in this nation, keep the following things in mind.

1. Decide the investment and investment period.
2. Pick an index.
3. Verify their identity.
4. Register with an Asset Management Company (AMC) or open an account with a broker selling index fund shares.
5. Start investing.

Now that you know how to invest in index funds in India, you must be aware of the limitation of this type of type.

What Are the Things to Consider Before Investing in Index Funds?

Risk Return Aspects: The risk-return aspect is another important parameter of investing. All investors want to invest their valuable money into something more secure and safe. Index funds track a market index and manage funds passively. Therefore, they are less volatile than actively managed funds and have less risk associated with them.

Note: As index funds mimic the performance or action of the index, investors must be careful about tracking errors. Hence, before investing in this type of investment instrument, investors must find a one with reduced tracking error.

Investment Plan: Every investor has an investment plan and returns expectation. For index funds, investors can opt for a long-term horizon. Though some market movements can be experienced in the case of short term, long term plans have low chances of direct market effect. Further, with an investment horizon, say of 7 years, you can expect an average return of 10%-12%. Thus, with an index fund, you can perfectly align with the other long term investment plan and continue investment activities as long as you want.
Taxability: Before investing, investors must know about the taxability of investment instruments. Like equity funds, index funds are subject to tax. The mention of tax leads us to the discussion of index funds tax benefits.
Limitations: Index funds do not offer flexibility to the fund manager while handling market downsides. In the case of active funds, fund managers have the liberty to select stocks in better managing markets at times when assets perform low due to bearish market conditions. However, index funds have to abide by the benchmark rules during both bearish or bullish market conditions. In addition, the returns are consistent but low in comparison to actively managed funds.

Also, as index funds follow index movement, changes in index composition lead to an adjustment of index funds which demands transaction cost. These costs reduce the benchmark returns.

Now that investors know about index funds, various types, working methods, benefits and everything related to it, they can invest in it as per their investment objective and suitable investment horizon.

Frequently Asked Questions

All

What is the ideal investment horizon of Index funds?

The ideal investment horizon of Index funds is 5 years or more. However, it can also vary depending on individual financial goals.

Is there any investment risk in index funds?

Yes, tracking error is a major risk for index funds.

What is the chargeable fee of an index fund?

As per the data of the Association of Mutual Funds of India, the chargeable fee of an index fund is capped at 1.5%.