Index Funds – Types, Benefits, How does It Work and How to Invest in 2023
What Is Index Fund – Meaning and Definition
An index fund is a passively-managed mutual fund that tracks the performance of a benchmark index, such as Nifty or a subindex, such as Nifty 50. Known for their low tracking error, zero human discretionary bias, and unbelievably low expense ratio, these funds have the potential to deliver higher returns.
However, bear in mind that like any other equity fund, an index fund, being market-linked, may be subject to some degree of risk and volatility. But you can mitigate the risks by staying invested for a long time.
To know more about the features and mechanisms of these funds, read on.
Key Takeaways:
- An index fund is built with a portfolio of stocks or bonds to match the components and performance of a market index like Nifty.
- These are passively-managed funds.
- The fund manager’s role is to build a portfolio whose holdings can match the index.
- These funds have a lower cost than actively managed funds.
- These funds have the potential to provide substantial returns in the long-term.
How do Index Fund Mutual Funds Work?
They follow a passive investment strategy, wherein the fund manager creates a portfolio that closely mirrors the underlying index. Unlike actively managed funds, index funds have little human interference and zero human bias. All a fund manager has to do is replicate the performance of the constituent stocks of the benchmark index, which reduces the fund’s tracking error. Now, how does this help?
Tracking error is an important indicator of the variability of a fund’s performance with respect to its benchmark. It is a measure of the difference between the returns or price fluctuations of the fund and that of its benchmark index.
Generally, funds with low tracking errors tend to generate better returns over a longer period of time. Also, low operating costs of these funds reduce the difference between the expected and the actual return, making them attractive investment options for anyone – seasoned investor and newbie alike.
Point to Note:
The portfolio of an index fund can change only when the constituents of its benchmark index change. In case such a fund is tracking a weighted index, fund managers could vary the proportions of different securities to match the weights of the index. This is typically called as weighting, which is done to balance out the influence of any single holding in an index.
By providing exposure to a broad range of securities, rather than just a few individual stocks, these funds can help you diversify your portfolio mix. This can also help reduce the overall risk of the portfolio.
What Are the Different Index Funds Types in India
1. Market Capitalisation Index Funds
Market capitalisation plays an important role in measuring the value of a particular index. In fact, Sensex, Nifty 50, Nifty Midcap 50, Nifty Next 50 and Nifty 200 are all market cap-weighted. This helps investors with a long-term investment horizon to get exposure to small- and medium-sized companies.
For example, investing in Nifty 50 could help investors capture the growth of top 50 companies in the long-term.
2. Broad Market Index Funds
They replicate the performance of a large group of stocks.
For example, a fund that tracks the NIFTY 500 index is a broad-market index fund. This is because it exposes people to stocks and market caps of different sectors.
3. Factor-based or Smart Beta Index Funds
Recently, factor-based or smart beta funds have got a lot of traction. For example, Edelweiss Nifty 100 Quality 30 Index Fund picks stocks from indices, such as Nifty 100 Quality 30. The stocks are picked on the basis of their quality as based on a score achieved upon analysing the last five years’ return on equity (ROE), financial leverage (debt/equity ratio), and earnings (EPS) growth variability. Factors, such as profitability, stable earnings, and lower leverage are taken into consideration while picking these stocks.
4. Equal Weight Index Funds
These funds assign every stock in the index the same weightage or percentage. For example, in the case of a fund tracking NIFTY 50, all the 50 companies will have an equal percentage.
5. Sector-based Index Funds
These funds invest in equity shares of companies belonging to the same industry or sector. Many sector-specific funds are available for popular sectors, such as banking, technology, consumption, and healthcare industries.
Although sector-based funds are for broad categories, there are funds catering to narrow categories as well. A person can choose to invest in banking which is a broad category. However, he/she can choose to invest in a private bank/PSU bank.
6. Debt Index Funds
These passively managed funds invest in debts and can help you achieve your long-term financial goals by providing steady risk-adjusted returns.
However, these funds are not completely risk free. Debt funds have an inverse relationship with interest rates. So, every rate hike will create some volatility in your portfolio. In addition, there is the question of credit risk, where the issuer defaults on their payment obligation and you end up suffering a loss. It is also not very liquid. But, these funds are extremely stable over sufficiently long horizons and can help you balance the underlying risks of equities or equity funds in your portfolio.
7. Custom Index Funds
These are the DIY (Do-It-Yourself) funds. Why? Because unlike standard funds, they don’t fall into the ‘one-size-fits-all’ mould. Yes, the fund manager will still decide when and how to rebalance your portfolio. But, they will take into consideration not just market risks and opportunities, but also your personal preferences, financial goals, risk tolerance, tax saving goals, and even your values. It is perfect for those investors, who want to implement their own investing strategies under a passive framework, while enjoying the benefits of portfolio diversification, low-cost investing, and risk-adjusted returns.
8. International Index Funds
International funds are mostly Fund of Funds that specifically track US indices. These funds give Indian investors the opportunity to capture the growth in the US market. For example, Navi US Total Stock Market Fund of Fund invests in the Vanguard Total Stock Market ETF (VTI). VTI tracks the performance of the CRSP US Total Market Index which has 4000+ constituents, across small, mid and large cap companies, representing nearly 100% of the US investable equity market.
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Index Fund Advantages: What Are the Top Benefits?
1. Lower Cost
Since these funds are passively managed, they are inexpensive in terms of their operating cost (a.k.a. expense ratio) compared to actively managed funds. This is because the fund manager does not need a team of analysts or researchers for stock-picking and market-timing. Top funds of this type offer an expense ratio in the range of 0.2%-0.3% while actively managed funds typically charge 1.5-2.5%.
2. Diversification
Diversification is a key aspect of an individual’s investment portfolio. A well-diversified portfolio is less volatile and a safer mode of investing. These funds provide a broad market exposure as they invest in all the stocks that form a given index and as an investor you don’t need to worry about diversification.
3. Can Provide Better Returns
Historically, index funds have performed better than most other funds in the long term. So, if you’re looking for investing in a fund for the long term then these funds are the way to go. As a matter of fact, over the past couple of years, these funds have performed at par if not better than actively managed equity funds. You can choose to invest in some of the best performing index funds if you’re going for long-term investments.
Top 5 Index Funds in India
According to a recent news report, netflows in index funds more than tripled in 2022. So, why is India quickly warming up to them? It is because they are easy to invest in, are low-cost, have no human bias, and offer portfolio diversification. Here are the top 5 options in India in 2023.
| Serial No. | Fund Name | Features* |
| 1 | Navi Nifty 50 Index Fund | AUM: ₹659.17 CroreExpense Ratio: 0.06% NAV: ₹11.2771 |
| 2 | Axis Nifty Next 50 Index Fund – Direct Plan – Growth | AUM: ₹78.34 CroreExpense Ratio: 0.23%NAV: ₹9.4514 |
| 3 | Nippon India Index Fund – S&P BSE Sensex Plan | AUM: ₹367 CroreExpense Ratio: 0.15% NAV: ₹30.1049 |
| 4 | IDFC CRISIL IBX Gilt April 2028 Index Fund – Direct Plan | AUM: ₹3,024.96 CroreExpense Ratio: 0.16% NAV: ₹10.8359 |
| 5 | ICICI Prudential Nifty 50 Index Fund Direct Plan | AUM: ₹3,927.08 CroreExpense Ratio: 0.17% NAV: ₹181.245 |
Disclaimer: Mutual fund investments are subject to market risks. Read all scheme-related documents carefully before investing.
Who Should Invest?
1. Beginner Investors
These funds are a simple and easy-to-understand investment option, making them a good choice for individuals who are just starting out on their investment journey.
2. Investors Looking to Diversify their Portfolio
These funds provide investors with a diversified portfolio as these funds hold a basket of stocks across sectors that represent a particular market index.
3. Investors with a Long-term Investment Horizon
Such funds are known to provide substantial returns in the long term, making them a popular choice among investors with long-term goals.
4. Investors Looking for Low-cost Funds
The administrative and fund management costs are significantly lower for these funds. This reduces the overall cost of the fund, making them attractive for investors.
Point to Note: Even though these funds are prone to short-term market movements, you could earn substantial returns on your investments if you stay invested for the long-term. In fact, long-term investment risk for these funds is close to nil. However, consider your risk tolerance, investment horizon, and financial goals before investing.
How to Invest in Index Funds Online in India?
- Step 1: Register/sign up on the official website or app of an AMC
- Step 2: Complete your KYC verification
- Step 3: Select the name of the fund you want to invest in
- Step 4: Transfer the requisite amount
- Step 5: You can give a standing instruction to your bank if you want to opt for a SIP
How to Invest in Index Funds Offline in India?
- Step 1: Visit the nearest branch of an AMC or a distributor/broker.
- Step 2: Fill out the KYC form and the application form.
- Step 3: Based on your financial goals and risk appetite, choose the fund.
- Step 4: Select the mode of payment and pay the investment amount.
- Step 5: Provide the necessary instruction if you wish to invest via SIP every month.
Why Should You Invest in Index Funds in 2023
1. Broad Market Exposure
Investing in index mutual funds ensures diversity in one’s portfolio.
2. Easy Management
All that the fund manager needs to do is rebalance the portfolio periodically.
3. No Bias Investing
Regulation-based, automated investment methods eliminate the chance of bias in investment decisions.
4. Low fees
The operating and overall cost of these funds are low because there is very little human involvement.
What are the Factors to Consider While Choosing an Index Fund
1. Expense Ratio
Expense ratio denotes additional charges levied by mutual funds to finance its expenses, including operational costs, maintenance fees, and allocation charges, to name a few. Different funds offer different expense ratios. The lower the expense ratio, the better it is.
2. Tracking Error
Tracking error is the difference between the actual returns of the portfolio compared against the benchmark index. It’s an indication of the performance of the fund. Even though these funds are perfectly indexed against the benchmark, some divergence can creep in. A positive tracking error means that the fund has performed better than the benchmark and vice versa.
3. Benchmark Index
As there are funds for virtually every market index, it’s a critical factor in decision making. A large-cap-based index (Nifty 50, Sensex) may be more reliable and consistent. While a small-cap index (NIFTY Small cap 100, BSE Small cap) may offer higher returns but comes with an increased risk.
4. Buy Direct
These funds can also be bought in two modes – direct (via the fund’s AMC) and regular (via a distributor). A regular fund may charge as high as 2% as commission for the distributor, making the overall returns lower. Direct funds are the way to go.
5. Market Trends
A bullish market will always give a positive return while a bearish market will give a negative return. This is because these funds mimic the market despite the underlying market conditions. Make use of SIP investments to stay invested at all times. If you are starting your investment journey, you can start with an amount as low as Rs.500.
6. Duration of investment
Markets may be prone to fluctuations in the short term but are generally bullish in the long term. Invest for the long term to get reliable returns.
Are These Funds Tax-Free?
- If the holding period is less than 1 year, then gains are classified as short-term capital gains, which are taxed at a rate of 15%.
- If the holding period is 12 months or more, then gains are classified as long-term capital gains which are taxed at a rate of 10%. This is applicable if equity-oriented mutual funds exceed Rs. 1,00,000 in a year.
Index Fund Disadvantages: What are Some Underlying Risks
Like any market-linked financial instrument, these funds also carry risks as follows:
- Market volatility: Price and returns fluctuations in the benchmark index will impact the performance of the fund. This might introduce short-term unpredictability in your portfolio as well. However, by staying invested in the long term, you might be able to overcome such risks.
- Concentration risk: Certain indices assign a disproportionately high weightage to certain types of securities or asset classes. This could introduce concentration risk in your portfolio mix because downswings in the market price or position of that particular set of stocks or securities, could have an immediate negative impact on the performance of the fund.
- No protection against lack of business fundamentals: Some of the top indices in India choose constituents based on their cash flow, free-float market capitalisation, and cost management. However, other business fundamentals, such as debt, profitability, revenue, or assets are not considered. So, if a company slips due to fiscal policies, geopolitical uncertainties, or other market forces, these funds won’t guard your investment against loss.
Difference Between Index Funds and Actively Managed Funds
| Basis of Comparison | Active Funds | Index Funds |
| Involvement in buy-and-sell decisions | Fund managers are actively involved in the investment decisions | Fund managers are not actively involved in the investment decisions. They simply track the underlying benchmark index |
| Expense ratio | Active funds come with a higher expense ratio as the fund managers charge a higher fund management fees | Index funds are associated with a lower expense ratio as the fund managers follow a passive investing strategy |
| Risk | Risk is dependent on the quality of the underlying assets and the competency of the fund manager | Risk is not dependent on the ability of the fund managers. |
| Performance | Active funds focuses on outperforming the benchmark index | Index funds focus on replicating the performance of the underlying benchmark index |
Is Index Fund Better than Stocks?
Each has their own unique characteristics and can be appropriate investment options depending on your risk appetite and financial goals. Investing in passively-managed funds has several benefits – they are low-cost, have the potential to offer risk-adjusted and inflation-beating returns, and eliminate human bias. Investing in direct stocks could give you higher returns at a higher risk. So, if you’re a beginner investor, Index funds could be a better option. For direct stock investments, you need to have prior knowledge about market movements and investment strategy.
Overall, they are both good investment options, but it ultimately depends on an individual’s investment goals and risk tolerance. A well-diversified portfolio should include both.
Is Index Fund Better than FD?
The two have different objectives. While these passively managed funds track the market index to generate inflation-beating returns, FDs are deposit accounts offered by banks and NBFCs, which lets you earn interest on your deposits. Though FDs offer guaranteed returns, it is impossible to rely just on fixed deposits to generate inflation-beating returns. For instance, FD investments could give you a maximum 7% to 8% returns per annum, whereas passively-managed funds have the potential to offer more than 20% returns on your investment.
So, if you are looking for higher risk-adjusted (for long term investments) returns, investing in these funds could be a better option. However, in order to diversify your portfolio, you could park some amount in FDs and earn interest on them. Consider your investment goals, risk tolerance and investment horizon before investing in any of these avenues.
Final Word
Investing in Index mutual funds can be a good option if you’re looking for better returns in the long run. Ideal for long-term investments, passive funds can give your broader market exposure. For instance, if you decide to invest in the Navi Nifty 50 Index Fund or Navi Next 50 Index Fund, you can enjoy exposure to top stocks spread across varied sectors, ranging from pharma to financial services. Navi Mutual Fund is home to a host of low-cost funds that you could choose to invest in based on your investment goals.
FAQs
Ans: There’s nothing called “assured returns” when it comes to mutual funds. Similarly, it’s impossible to provide assurance that index funds will give better returns than actively-managed funds. However, index funds have the ability to give you broader market exposure. And going by recent records, index funds have been performing better than active funds. But then again, markets are unpredictable. So, if you’re just starting out, do substantial research and invest in the best-performing funds to steer clear of any risk.
Ans: An open-end index fund scheme can be redeemed anytime. However, for Equity Linked Saving Schemes (ELSS Funds), you can only redeem after the completion of the 3-year lock-in period.
Ans: Index funds mirror the index they track. However, one should note that the index fund returns are not always in sync with the index due to tracking errors. Index fund returns are similar to the gains offered by the index.
Ans: An index fund tracks the performance of a specific market index to offer risk-adjusted returns in the long-term. The fund comprises a portfolio of holdings which mirrors the constituents of the concerned index like Nifty 50.
Ans: Here are some of the best index funds you can consider to invest in:
1. Navi Nifty 50 Index Fund
2. IDFC Nifty 50 Index Fund
3. Nippon India Index Fund – S&P and BSE Index
4. UTI Nifty 50 Index Fund
5. HDFC Index Fund – S&P and BSE Index
Ans: As a beginner investor, you can start investing in index funds via SIP. Investing in SIPs brings financial discipline to an investor’s life. Also, if you want to start with small equity investments, SIP is the way to go.
Ans: Index funds are a type of passively-managed mutual funds. You can either invest in actively managed funds where there’s human bias in terms of buying and selling of stocks or in passive funds where there is no human bias – the fund merely mirrors the constituents of the concerned index. Both actively managed and passively managed funds have their own sets of benefits and risks. Consider your investment goals and risk tolerance before selecting any of these funds.
Ans: You can buy index funds directly through an AMC or Asset Management Company.
Ans: Index funds are market-linked schemes and the performance of these funds is based on the performance of the benchmark index, which can go up or down based on the market. However, you can mitigate these risks by staying invested for the long-term.
Ans: Index funds are taxed just like any other equity funds. When the period of holding of index fund units is more than 12 months, LTCG tax of 10% is levied on the gains exceeding Rs.1 lakh. When the period of holding is less than 12 months, 15% STCG tax is levied on the gains earned. LTCG below Rs.1 lakh is exempt from tax.
Ans: There are no such disadvantages as such just that index funds could be prone to short-term market fluctuations. However, these risks could be avoided if you stay invested for the long term.
Ans: Index funds have the potential to generate substantial returns in the long-term. However, the return on your investment is completely based on your investment strategy. Our suggestion would be to go for the long-term game and keep your portfolio diversified.
Ans: The myth is you need a substantial amount of money to invest in mutual funds. However, that is not true. You can start an SIP with a nominal amount. For instance, Navi Mutual Fund investments – both lump sum and SIP – start at Rs.10.
Ans: Investing in index funds comes with a lot of benefits – exposure to a diversified portfolio, low-cost investments, zero human bias, and potential to generate risk-adjusted and inflation-beating returns in the long-term. So, you can consider investing in index funds, especially if you are looking to invest in the equity at a lower-cost and lower-risk.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
