An index fund is a kind of passive investment that aims to mirror the performance of a specific index rather than trying to outperform it. Here we’ll look at what index mutual funds are, how they work, and all that you should know before investing in them.
What are Index Funds?
Every actively managed mutual fund like flexicap or ELSS has a benchmark or an index that it aims to outperform. In these options, fund managers try to beat the benchmark through their expert decision-making and research-driven stock selection. However, a classification of mutual funds called index funds takes a different, more passive route. Instead of trying to beat the market, such funds aim to mirror its returns.
For example, the portfolio of an index fund following the Nifty 500 index will consist of the top 500 Indian companies represented in the index, and in the exact same proportion. Similarly, a Nifty 50 index fund portfolio will contain the top 50 Indian companies in the respective weightage. Thus Index Funds Meaning can be understood as those funds which are designed not to outperform the market, but to deliver returns in line with a specific market benchmark. There are various types of index funds one can choose from. Have a look at them below:
Types of Index Funds
1. Market Capitalisation Index Funds
Most of the index funds you can find belong to this category, as they track indices based on the market capitalisation of companies. Examples under this variety include Nifty 50, Sensex, Nifty Midcap 150, Nifty 200, or Nifty Next 50 funds. Companies with higher market capitalisation carry more weight in the fund. So if Reliance Industries holds 12% weight in the Nifty 50 index, then a Nifty 50 index fund will also allocate approximately 12% of its assets to Reliance Industries.
2. Equal-Weight Index Funds
Unlike funds weighted by market cap, equal-weight index funds give the same allocation to each stock in the index, irrespective of the company’s size. For instance, in an equal-weight Nifty 50 fund, Reliance Industries will have a 2% allocation despite having a market cap of 12%. Similarly, each of the 50 stocks will have a 2% allocation.
3. Broad Market Index Funds
These are index funds that track broader indices like the Nifty 500 or BSE 500, thus offering greater exposure and diversification to investors by investing in a large number of companies across different market caps (large-cap, mid-cap, and small-cap).
4. Debt Index Funds
As the name suggests, these funds track indices of debt instruments such as government securities, corporate bonds, or treasury bills. These funds help reduce interest rate risk and credit risk and are ideal for conservative investors looking for stable returns.
5. International Index Funds
These funds allow you to diversify your portfolios as they invest in the international market. You don’t need to open a separate account and can easily invest in lucrative opportunities offered by global markets. International index funds replicate global indices like the S&P 500, Nasdaq 100, or Hang Seng index.
6. Sectoral Index Funds
These are high-risk funds which mirror indices specific to a particular sector such as IT, pharma, banking, PSU, consumption, infrastructure, or energy. They invest only in companies within that sector and mirror the sectoral index composition.
How do Index Funds work?
You know what an index fund is, but how does it work? Well, index funds work just like any other mutual fund scheme in terms of pooling investors’ money and investing it in a basket of securities. What sets them apart is their investment strategy. These funds take a passive approach to management. Instead of relying on a fund manager to pick stocks, an index fund tracks the relevant market index.
This means that if an index fund is following the Nifty 50 Index, it’ll allocate its resources to the 50 companies within the benchmark and according to their market cap. If Infosys covers 8% of the index, then about 8% of your money will go into Infosys shares.
The fund’s objective here is to track the benchmark’s returns as closely as possible. Since the fund manager is not adding any value through active stock selection or market timing, index fund make fewer decisions and trade less, which translates to a lower expense ratio for the investor. In actively managed funds, the manager aims to outperform the fund’s benchmark and generate higher returns than the market, that’s why the costs associated with these funds are also higher. The beta of index fund, which measures the volatility of a fund’s returns relative to the market, is 1. That means the fund’s NAV will move in line with the market. Similarly, the alpha of such a fund is zero.
How Does Index Fund Taxation Work?
Tax treatment of index funds depends on the type of income generated. The regular income earned from IDCW funds is taxed according to the investor’s tax slab, and the mutual fund house must deduct 10% TDS in case this income exceeds Rs. 5,000 in a financial year.
Capital gains are taxed based on the investment’s holding period. LTCG (long-term capital gains) and STCG (short-term capital gains) tax rates vary and are applicable depending on the fund’s asset allocation. Index fund holding more than 65% of their assets in equity or equity-related instruments are taxed at 20% STCG if the units are sold within 12 months, and 12.5% LTCG for investments held for more than a year. LTCG up to Rs. 1.25 lakh per financial year are exempt from tax. Capital gains from debt-focused funds are added to your income and taxed as per your applicable slab rate, irrespective of the holding period.
With recent changes in Budget 2023 and 2024, you may find it confusing to navigate mutual fund taxation. That’s why it’s recommended to consult a qualified online tax advisor who can not only ensure you comply with the latest tax rules but also minimise your tax burden through personalised planning.
Benefits of Investing in Index Funds
Wondering Why to Invest in Index Funds when there are so many actively managed mutual funds available in the market? Check out these Index Fund Benefits to understand why they deserve your consideration:
1. Lower Expense Ratio
Actively managed mutual funds charge higher management fees as they employ expert fund managers and research teams. This can chew your returns in the long run. Since index fund are passively managed, they end up not charging as much towards covering the fund’s operating expenses which ultimately results in lower expense ratios.
2. Diversification
Like any other mutual fund portfolio, index funds boast a built-in diversification that helps lower risk across a wide range of securities. By replicating a benchmark index these funds include multiple companies from various sectors and market caps. For example, a Nifty 50 index fund will likely invest in leading companies such as Infosys, Reliance, and HDFC and spread risk across well-established companies.
3. No Human Bias
Not all of the decisions made by active fund managers work out. As index fund invest in securities included in the benchmark, they lower the qualitative risk associated with poor judgment and decision-making.
Who should invest in an Index Fund?
Index funds tend to be more predictable than actively managed funds as they closely track a benchmark without frequent buying or selling. This makes them a good fit for investors who prefer a low-maintenance, cost-effective, and long-term investment. They are also less risky compared to actively managed funds as a manager’s decisions can lead to underperformance due to incorrect bets or emotional biases.
Since index fund make no attempt to outsmart the market, the chance of missteps is lower. However, this should not deter you from investing in actively managed funds as their appeal is their aim to beat the market. Skilled managers can deliver very high returns during bullish phases which index funds may not.
You should ideally seek advice from a personal financial planner to see whether investing in index funds would be a good choice for your financial situation, goals, and risk tolerance. They can guide you from start to finish by helping you understand How to Invest in Index Fund, which funds to pick, how much to allocate, and the most tax-efficient way to invest based on your income and long-term objectives.
How do index funds invest?
An index fund replicates the benchmark it’s tracking, so the portfolio is a copy of the securities within that benchmark. For example, international index funds tracking the S&P 500 index will include companies like Apple, Nvidia, Meta, and Microsoft in the same proportion as they are represented in the S&P 500.
Depending on your financial situation and goals, you can invest a lump sum or make regular contributions via an SIP. A Systematic Investment Plan allows you to invest fixed amounts at regular intervals, helping instil discipline and reducing the risk of market timing. You also benefit from rupee cost averaging which averages out the investment’s cost over time. Connect with our expert investment consultant today to start your index funds SIPs. Before we get into how to buy index fund, let’s take a look at some factors you should consider before investing.
Factors to consider before investing in Index Funds in India
Keep these aspects in mind when selecting index funds:
1. Risk and Returns
It’s true that index mutual funds are often considered less risky than actively managed funds due to their diversified and passive nature, but they are still subject to market risk. If the index falls, so will your investment’s value. And also, since these funds mirror the market, they will never outperform the index and will only deliver returns that are very close to it. Some index fund are more risky than others depending on what type of index they track. For example, a fund tracking the Nifty 50 is generally more stable and less volatile as its portfolio consists of the top 50 large-cap companies. On the other hand, sectoral index funds or small-cap index fund carry higher risk.
2. Expense Ratio
The expense ratio is the annual fee charged by the AMC to manage the pooled funds. As index funds are passive in nature, they require minimal management making the expense ratios much lower than actively managed funds. The lower the expense ratio, the more of your money stays invested and continues to grow.
3. Tracking Error
Tracking error is a measure used to analyse how closely an index fund follows its benchmark. If the error is high, that means the fund is not doing a good job of mirroring the index returns. Look for funds with consistently low tracking errors to ensure minimal deviation from benchmark performance.
4. Tax
Tax treatment of index mutual funds depends on the investment’s holding period and the kind of assets the fund invests in. Equity-oriented index funds (with over 65% allocation to equities) are taxed as:
- Short-Term Capital Gains: 20% if sold or redeemed within 12 months
- Long-Term Capital Gains: 12.5% for gains exceeding Rs. 1.25 lakh in a financial year (after 12 months holding period)
Debt-based index fund, on the other hand, are taxed as per your income tax slab, regardless of the holding period.
5. AMC Reputation and Fund Size
You should always go for asset management companies with a solid track record in fund management and transparency. The total AUM of the AMC can be used to assess their reliability. The AUM of the index fund is also important as it indicates trust among investors.
6. Personal Considerations
And as any professional wealth advisor would tell you, the best index fund to invest in aren’t necessarily the ones with the highest past returns, but rather the ones that compliment your financial goals, investment horizon, and risk appetite.
Final Thoughts
Index funds aim to mirror the performance of a market index rather than beat it like actively managed funds. This results in market-matching performance with lower fees which makes them appealing to investors who prefer a more passive approach.
If you’re looking for suitable index funds to invest in, don’t hesitate to reach out to us. Our experts can help you understand how index fund fit into your financial plan, compare options based on factors like expense ratios, tracking errors, and past performance, set up investments through SIPs, and make your investments more tax-efficient.
FAQs
1. What are the benefits of index funds?
Since index funds don’t need to be actively managed, their expense ratios are much lower. In the long run, low cost index fund can significantly boost your returns, simply because more of your money stays invested and benefits from compounding over time.
2. Are index funds risk free?
No, they are not risk-free investments as their performance is market linked. If the index the fund is tracking drops, so will the fund’s value. Even though they carry risks, index fund are relatively safe due to broad diversification and passive strategy. They’re comfortably safer than investing in individual stocks.
3. What are the differences between index funds and actively managed funds?
Index funds passively track a market index like the Nifty 50 to match its performance, whereas actively managed funds try to outperform the market through a fund manager’s research and decisions. Due to this passive style, index fund have lower expense ratios and their returns never beat the market’s.
4. Can I invest globally through index funds?
Yes, you can! International index fund such as those following the S&P 500, and Nasdaq-100 indices allow you to gain exposure to global markets.
5. How can I choose the best index funds?
Assess factors such as tracking error, expense ratio, fund size, and the past performance of the index being tracked. Always remember that the best index funds to invest in are the ones that align with your unique financial situation, so make sure to match your choices with your goals, risk tolerance, and risk appetite.
