What is an Index Fund?

An index fund is a type of mutual fund that purchases similar stocks as in a particular market index. This implies that the scheme will perform in tandem with the benchmark index it tracks.

Index funds often catch investors’ attention as they intend to replicate the performance of their underlying index– like the Sensex or the Nifty. All the stocks in these indices will find some representation in their investment portfolio. This theoretically ensures a performance identical to that of the index, which is being tracked.

How do Index Funds work?

When an index fund tracks a benchmark like the Nifty, its portfolio will have the 50 stocks that comprise Nifty, in the same proportions. An index is a group of securities defining a market segment. These securities can be bond market instruments or equity-oriented instruments like stocks. Some of the most popular indices in India are BSE Sensex and NSE Nifty. Since index funds track a particular index, they fall under passive fund management. The fund manager decides which stocks have to be bought and sold according to the composition of the underlying benchmark. Unlike actively managed funds, there isn’t a standalone team of research analysts to identify opportunities and select stocks as index funds track an index.

While an actively managed fund strives to beat its benchmark, an index fund’s role is to match its performance to that of its index. Index funds typically deliver returns more or less equal to the benchmark. However, there can be a small difference between fund performance and the index. This is referred to as the tracking error. The fund manager must work towards bringing down the tracking error as much as possible.

Benefits of investing in index funds

Following are some of the advantages enjoyed by index funds:

  1. Low fees
    Since an index fund mimics its underlying benchmark, there is no need for an efficient team of research analysts to help fund managers pick the right stocks. Also, there is no active trading of stocks. All these factors lead to low managing cost of an index fund.
  2. No bias investing
    Index funds follow an automated, regulation-based investment method. The fund manager is provided with a defined mandate of the amount to be invested in index funds of various securities. This eliminates human discretion/bias while taking investment decisions.
  3. Broad market exposure
    Investing money in a proportion similar to that of an index ensures that the portfolio is diversified across all sectors and stocks. Thus, an investor can seize the probable returns on the larger segment of the market through a single index fund. For instance, if you decide to invest in the Nifty index fund, you enjoy investment exposure to 50 stocks spread across 13 sectors, ranging from pharma to financial services.
  4. Tax Benefits of Investing in Index Funds
    Since index funds are passively managed, they usually enjoy low turnover, i.e. few trades placed by a fund manager in a given year. Fewer trades results in fewer capital gains distributions that are passed to the unitholders.
  5. Easier to manage
    Since fund managers do not have to worry themselves with how stocks on the index are performing in the market, index funds are easier to manage. A fund manager just needs to rebalance the portfolio periodically.

Who should invest in Index Funds?

You should invest in mutual funds according to your investment horizon, goals, and risk appetite. Index mutual funds are ideal for those investors who are risk-averse. Such funds do not require extensive research and tracking. For instance, if you want to invest in equities but do not want to expose yourself to the risks associated with actively managed equity funds, you can opt for a Nifty or Sensex index fund.

What things should you consider as an investor?

You should consider the following features of index funds before you decide to invest in them:

  1. Index Fund Returns
    Index funds aim to replicate the performance of their market index. Unlike actively managed funds, they do not try to beat the benchmark. However, the returns generated may not always be at par with that of their underlying index owing to tracking errors. The lower the errors, the better the index fund will perform.
  2. Risk tolerance
    Since index funds map a particular market index, they are less prone to equity-linked risks and volatilities. It’s a good idea to invest in index funds to generate optimal returns amid a rallying market. However, things could get ugly during a market downturn as index funds tend to lose their value during a slump. Hence, it is always advised to have a mix of actively and passively managed index funds in your portfolio.
  3. Cost of investment
    The expense ratio of index funds is usually 0 less, as compared to actively managed funds This is because the fund manager is not required to formulate any investing strategy for index funds. However, it should be noted that even a fund with a lower expense ratio has the potential to generate higher returns on investment.
  4. Taxation
    You earn capital gains, which is taxable, upon redeeming the units of your index fund investment. The rate of taxation depends on your holding period, i.e. how long you stay invested. Short-term capital gains (STCG) or gains earned with a holding period of up to 1 year are taxed at 15% (plus surcharge as applicable plus 4% Health & education cess). Long term capital gains (LTCG) from funds held for more than 12 months attract long-term capital gains tax at 10% (plus surcharge as applicable plus 4% Health & education cess) if the total long term capital gains amount from equity oriented mutual funds/ equity shares exceed ₹1,00,000 in a year.
  5. Investment horizon
    Index funds can experience a lot of fluctuations in a short period. These fluctuations have the potential to average out the gains on your investment if they last long. Hence, index funds are ideal for those with a long-term investment horizon. If you choose to invest in index funds, you must be patient enough to allow the fund to perform at its maximum potential.

The financial takeaway

Index funds are popular because they are a low-risk, low-maintenance, low-cost way to see steady returns over time. But no investment is one-size-fits-all. To see if they suit you, ask yourself:

Am I looking to invest for the future? Index funds are best suited for investors with a long-term horizon: While the market historically rises over time, you do need time to weather the bumps.
Am I the buy-and-hold type? Index funds are ideal for those who aren’t interested in picking stocks.
Am I comfortable with slow gains? Index funds typically perform better than actively managed funds over time, but gains are usually moderate. Actively managed funds can sometimes see higher returns in the short term.

Any investment has some risk attached to it, of course. But index funds rank fairly low on the risk spectrum – and are certainly more cost-effective than trying to buy stocks on your own.

“Investors simply can’t afford to make oversized bets on individual securities,” says Johnson. “Investing in a broadly diversified basket of securities is a more prudent strategy.”