What Are Index Funds: Index Fund Types And Advantages

Index funds have been around in India for a couple of decades now, but have started gaining more and more popularity recently. According to Morningstar Research in the United States, for 2018, index mutual funds saw an inflow of $458 billion while actively managed funds saw an outflow of $301 billion. Similar trends are emerging in India as well.

What are Index Funds?

An index fund is a type of mutual fund that mimics a given financial market index eg. NSE Nifty, BSE Sensex, etc. There is an index fund for nearly every existing market. Recently, there has been a massive surge among investors regarding index funds, primarily due to the funds’ performance in the last couple of years. This has led many AMCs to launch passive funds. 

A financial index typically consists of a portfolio of stocks with each stock assigned a weightage. An index mutual fund mimics an index by investing in the same set of stocks in the same weightage as the underlying index. Such funds are therefore a passive form of investment, where, unlike an actively managed fund, the investment strategy does not change frequently.

How do Index Funds Work?

An index fund is a passively managed diversified equity fund that tracks a particular benchmark index. Basically, an index mirrors a market segment, i.e. securities that are a part of the same segment are grouped together to form an index. 

For example, an index fund tracking NSE NIFTY index has 50 stocks in its portfolio, which is the same as Nifty 50. Moreover, the weightage of the underlying assets is the same as that of the underlying benchmark. 

As these funds track a particular index, the fund managers are not actively involved in the decision-making process. Moreover, the NAV (Net Asset Value) of an index fund moves in sync with the index it is tracking. For example, if NIFTY 50 rises 10%, the NAV of an index fund linked to NSE NIFTY will also more or less appreciate around 10% over the same timeframe. 

Therefore, returns from index funds are more or less similar to the benchmark. The performance difference, if any, is known as ‘tracking error.’

Note* – The best index fund is one with a minimum ‘tracking error.’

Different Types of Index Funds in India

The different types of index funds are as follows: 

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 are all market cap-weighted. 

It is a known fact that the stock market goes through ups and downs. However, every stock cannot get undervalued or overvalued at the same time. 

A market cap index provides a high weight to an overvalued stock and a low weight to an undervalued stock. 

2. Broad Market Index Funds

A broad market index fund replicates the performance of a large group of stocks. 

For example, an index 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

Nowadays, computers are used to analyse complex data and financial metrics. The results are categorised under various factors. Such factors are momentum, value, quality, volatility, etc. 

Factor-based index funds are increasingly becoming popular. In fact, fund houses offer multi-factor index funds, i.e , index funds using 2-3 factors. 

4. Equal Weight Index Funds 

When every stock in the index is of the same weight or percentage, it is known as an equal weight index fund. For example, in the case of an index fund tracking NIFTY 50, all the 50 companies will carry an equal percentage. 

5. Sector-based Index Funds

When a fund is being invested in equity shares of companies belonging to the same industry or sector, it is known as a sector-based index fund. There are many sector-specific index funds available for banking, technology, consumption and healthcare industries. 

Although sector-based funds are for broad categories, there are index 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

Individuals who invest in debt instruments know the risks involved, mainly volatility in the price of bonds and credit risk. 

Although debt index funds are not really popular in India, they are capable of reducing the credit risk and interest rate risk in a portfolio.

7. Custom Index Funds

Custom index funds enable asset houses to formulate their own investing strategies under a passive framework. These strategies are based on data processing and analysis.

Technological advancement is encouraging Indian asset management companies to set up custom index funds. 

8. International Index Funds

International index funds are becoming popular in India. Many funds track the USA-specific S&P 500 index, the NASDAQ index and the NYSE FANG+ index. Some funds track the Hang Seng index as well.

Advantages of an Index Fund

1. Lower Cost

Since index 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. Good index funds offer an expense ratio in the range of 0.2%-0.3% while actively managed funds typically charge 1.5-2.5%. This could mean a significant difference in your overall returns depending on your portfolio.

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. Index 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

Generating returns better than the market is extremely hard. All actively managed funds try to outperform the market but few ends up actually doing that. For instance, in the last 5 years only 11 % of actively managed large-cap funds in India have performed better than the benchmark index. A higher expense ratio of these funds also plays an important role in overall returns. Index funds tend to perform better than most funds in the long term. So, if you’re looking for investing in a fund for the long term then index funds are the way to go. As a matter of fact, over the past couple of years, index funds have been performing 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.

Difference between Actively Managed Funds & Index Funds

The table below provides the key differences between index funds and active 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

Who should Invest in Index Funds?

Before investing in mutual funds, you should consider your investment horizon, goals, and risk appetite. Though considered by most risk-averse investors, you should do enough research on fund performance before investing. However, if you’re looking for broad market exposure or are just starting out investing in equities, index mutual funds could be a good investment avenue. For instance, if you want to invest in equities but are wary of the risks associated with actively managed equity funds, you can opt for a Nifty or Sensex index fund.

How to Invest in Index Funds Online in India?

Given below are the steps on how to invest in index funds online:

How To Invest in Index Funds Offline in India?

Alternatively, you can invest in mutual fund schemes via different online investment platforms.

Offline:

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.

Top Reasons to Invest in Index Funds in India

The list of reasons for investing in index funds are as follows:

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 method eliminates the chance of bias in investment decisions

4. Low fees

One doesn’t need analysts to help in choosing stocks. There is no active trading of stocks because an index fund mirrors the benchmark.

How are Index Funds Taxed?

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.

Things to Keep in Mind 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 index 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

Like all mutual funds, index 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 an index fund mimics 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.

Final Words

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 index funds that you could choose to invest in based on your investment goals.

Happy indexing!

FAQs on Index Funds

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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.