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Index funds are passive mutual funds that imitate the benchmark market indices. A mutual fund consists of a pool of money collected from the investors that invest in stocks and bonds, and an index fund utilizes the cash collected to invest in companies that make up a particular index.
In index funds, the fund manager doesn’t play an active role in selecting the stocks, but invests in all the stocks that make up a particular index. The weightage of stocks in the fund closely matches that in the index, they mirror the index they track, are well diversified, and hold lower risk than individual stock investing.
Mutual funds are generally actively managed by the fund managers who select the stocks. Their aim is to generate market-beating returns and for this, they have a dedicated team of research analysts. But the index funds are a form of passive investing where the goal is to match the market performance. The fund manager in the index funds doesn’t need to actively manage the stocks and bonds as they are just copying a particular index. Whenever there is a change in the weight of a particular stock in the index, the fund manager buys or sells the units of the stock to make the portfolio more aligned to the index.
As against the actively managed funds that try to beat the market, the index fund is designed to match the performance of its index. But the fund may not always produce the same result as the index due to the tracking error. The tracking error occurs as it is always not possible to hold the securities in the same proportion as that of the index and there are transaction costs involved in buying and selling the securities.
Passive investors believe in trading as little as possible and look for gains over a longer period of time. They don’t worry about the short-term fluctuations in the market and want to build their wealth gradually. So they invest in index funds.
There are the large-cap index funds that replicate the Nifty 50 or the Sensex, mid-cap index funds, small-cap index funds, global index funds (passive funds focusing on different countries), and sectoral or focused index funds.
Advantages of investing in index funds-
1) Fees are Low-
The fees charged by the index funds are much lower as the fund managers just track an underlying index. They don’t try to beat the returns of the index so the team of research analysts required is very small thereby reducing the expenses. The transaction costs are reduced due to the lesser number of transactions.
2) Tax efficiency-
The buy and hold strategy results in tax efficiency and there is less capital gains tax.
3) Diversification-
When you buy units of an index fund there is diversification across stocks and sectors. The Nifty 50 consists of 50 stocks and is diversified across 13 sectors of the economy. An index fund tracking Nifty fifty would be diversified across a similar number of stocks and sectors.
4) No investing bias-
In index investing the fund manager is provided with a mandate to invest in various securities of an index fund. There is an automated investment procedure. This removes the bias that the fund manager may have towards a particular sector thereby reducing the chances of human error.
5) Easy to Manage-
The fund manager has to just track the index and rebalance the stocks. They need not worry about their performance.
Disadvantages of Index Funds-
Small returns-
Index funds are supposed to track the index so they can’t beat the market. A fund manager in an active fund tries to beat the market returns which come with higher risks. The returns in index funds are less as compared to a successful actively managed fund.
Who should invest in an Index Fund?
A person should invest in an index fund depending on his investment goals, risk appetite, and the time horizon. Index funds are good for persons who don’t want to take much risk. A person who is interested in investing in equities but does not wish to expose himself to the risks of an actively managed fund can consider investing in an index fund.
Things to consider by an investor before investing in an index fund-
1) Returns of an Index fund-
Index funds try to replicate the performance of their benchmark index. But the returns generated may not be similar to their benchmark due to the tracking error. So always check for the tracking error and the lower the error the better the performance of the fund would be.
2) Risk Tolerance-
Index funds track a particular index so they are less prone to volatility like the individual stocks and actively managed funds. They provide optimal returns during a rallying market but the returns could suffer during the market downturn. It is a good idea to invest in both actively managed funds as well as index funds.
3) Expense Ratio-
The expense ratio is a percentage of the fund’s asset that the fund house charges as a fund management fee. It includes costs such as administrative, compliance, distribution, management, marketing, record keeping, etc. It is generally lower for the index fund as the fund manager does not have to make an investment strategy like the actively managed fund. The fund with a lower expense ratio has the potential to provide higher returns for the investors.
4) Investment horizon-
Index funds are recommended for investors with an investment horizon of six years and above. In the short term, there would be lots of fluctuations in the market. But over the longer term, these fluctuations average out, so the index funds are ideal for long-term investment horizon and perform well for a patient investor.
Exchange-traded funds-
Exchange-traded funds or ETFs are a collection of securities that follow an underlying index. These funds use various investment strategies and invest across industry sectors. The ETFs are listed on the exchanges and can be traded throughout the day like stocks. However, there are some differences between the index funds and the exchange-traded funds (ETFs)-
Index fund Vs ETFs-
Taxation of Index Funds-
The index funds are taxed like any equity fund. The rate of taxation depends on the time period for which you hold the index fund. Short-term capital gains are realized when you sell the units within a year of purchase and are taxed at a rate of 15%. Long-term capital gains are realized when you sell the units after holding them for more than a year. Gains up to Rs. 1 lakh are tax-exempt while any gains above this limit are taxed at a rate of 10%.
Best Index Funds in India-
The best index funds in India for investment are-
1. DSP Equal Nifty 50 Fund.
2. IDFC Nifty Fund.
3. Nippon India Index Fund.
4. UTI Nifty Index Fund.
5. ICICI Prudential Nifty Index Fund.
6. SBI Nifty Index Fund.
7. HDFC India Sensex Fund.
8. Tata Index Sensex Fund.
9. ICICI Prudential Sensex Index Fund.
10. Franklin India Index Fund.
The index funds charge smaller fees as compared to the active funds and this difference in fees can have a large effect on the returns of the investors over a longer period of time. This is the reason why index funds are becoming popular with investors. Besides this, they offer diversification to the portfolio.