Index funds replicate stock market indices, aiming to mirror their performance. These funds are passively managed and require minimal effort in your portfolio. These are relatively less volatile and risky than active funds, making them ideal for long-term investments.
Index mutual funds are a type of passively managed mutual fund designed to track the performance of a specific market index, such as the NIFTY 50, NIFTY Next 50, or Sensex. Instead of relying on a fund manager’s expertise to make stock selections, these funds simply replicate the holdings of the chosen index. This means that they hold the same stocks as the index in the same proportion.
Unlike actively managed funds, where fund managers take strategic decisions about which stocks to buy and sell, index funds follow a more straightforward approach. The goal of an index fund is to match the performance of the index it is tracking, rather than trying to outperform it. This style of investing eliminates the need for constant buying and selling of stocks, making it a more cost-effective option for investors due to lower transaction costs and management fees.
In actively managed mutual funds, fund managers actively choose and trade securities to maximise returns. However, in passive investing, fund managers simply aim to mirror the performance of the index, offering a less hands-on approach. As a result, index funds are typically more affordable and can be a suitable option for investors looking for a low-cost, long-term investment strategy.
Index mutual funds are a popular choice for those who prefer stability and minimal risk, as they offer broad market exposure and tend to perform in line with the overall market, making them a simple and efficient way to invest.
How do Index Funds work ?
An index fund is a type of diversified equity fund that operates differently from actively managed funds. In an index fund, there is no active involvement of a fund manager in selecting individual stocks. Instead, the fund aims to replicate the performance of a specific stock market index, mimicking both the choice of stocks and their respective weightings within the index.
This close correlation between the index and the index fund’s portfolio means that the Net Asset Value (NAV) of the fund closely mirrors the movements of the index it tracks.
For example, if the underlying index, such as the Sensex, increases by 10% in a month, the NAV of the Sensex-linked index fund will also roughly appreciate by approximately 10% during the same period. Conversely, if the Sensex declines by 10%, the NAV of the index fund will similarly decrease by about the same percentage.
Index funds are popular for their simplicity and the fact that they provide investors with a way to passively invest in the broader market’s performance.
Features of Index Funds
The following are some of the basic features of index funds:
Lower costs – As discussed above, the fees are lower for index funds when compared to actively managed mutual funds.
Risk and return – Indices generally gain in value over time, but the rate of return is lower than that of a more actively managed fund. In fact, beating the index performance is usually an objective of any actively managed fund.
Tracking error – If the portfolio of an index fund is not a hundred percent the same as that of the index that it is trying to mirror, then the fund is said to have a tracking difference. It is an important feature that should be checked while assessing the fund. We will read more about tracking errors in a later section.
Long term investment– If investors have a large chunk of their investment in index funds, then they must wait patiently for their investment returns to come. Indices may not increase every year and may see many downtrends in the short run.
Advantages of Investing in Index Funds
Investing in index funds has gained traction in India due to their unique benefits over actively managed funds. While active funds are still popular for their potential to outperform market indices, index funds offer distinct advantages that appeal to investors seeking a more streamlined and cost-effective approach to investing.
1. No fund manager bias
One of the primary advantages of index funds is the absence of fund manager bias. In an actively managed fund, the fund manager makes decisions about stock selection, which can be influenced by personal beliefs or market predictions. However, in an index fund, the fund manager’s role is to simply replicate the index being tracked. For instance, a fund that tracks the NIFTY Next 50 Index will only invest in the exact 50 stocks that comprise the index, and the proportion of each stock in the fund is the same as the index. This removes the risk of human error or subjective bias in investment decisions, ensuring that the fund remains aligned with its benchmark.
2. Low cost of investment
Index funds typically have a lower expense ratio compared to actively managed funds. This is because managing an index fund doesn’t require an extensive team of analysts to research market trends or identify the best stocks. Since the portfolio merely mirrors the index, there is no need for constant stock picking or trading, which also reduces portfolio turnover. This lower management and transaction cost make index funds more affordable, especially for long-term investors seeking to maximise returns while minimising fees.
3. Diversification across sectors
Another significant benefit of index funds is diversification. Since most indices represent a broad basket of stocks from various sectors, index funds provide exposure to a wide range of industries. This diversification reduces sector-specific risks and helps investors spread their investments across different parts of the economy. Additionally, index funds follow strict guidelines that limit exposure to individual stocks, further lowering the risk of over-concentration in any one stock or sector.
Risks involved in Index Funds
Tracking difference and tracking error – Tracking difference is the difference between the performance of an Index Fund (in terms of its NAV) and that of the benchmark index being tracked by the fund. The variability in the tracking difference over some time is known as the tracking error. A fund with a high tracking error and regular negative tracking difference means that the fund is regularly failing to meet the performance of the benchmark index and is thus not good for investment.
Economic downturn – Indices fall during a general economic downturn. Therefore, during such periods of negativity in the market, it is better to switch your holdings into either safe havens like gold or specific equities or commodities which are performing well.
Factors to Consider Before Investing in Index Funds
When considering investing in index funds in India, it’s essential to evaluate a few key factors to ensure they align with your financial goals. Index funds offer simplicity and cost-effectiveness, but certain elements need to be understood before you make an investment decision.
1. Risks and returns
Index funds are passively managed, meaning they mirror the performance of a market index. As a result, they tend to be less volatile than actively managed funds, offering relatively stable returns. However, index funds don’t have the flexibility to outperform the market during downturns. During market rallies, these funds can deliver good returns, but in bearish markets, actively managed funds might perform better. Therefore, it is often recommended to maintain a balanced portfolio with both index funds and actively managed funds. Additionally, keep an eye on tracking error, which measures how closely the fund follows its index. Choosing funds with low tracking errors ensures better alignment with the index’s performance.
2. Expense ratio
The low expense ratio of index funds is one of its primary benefits. Since they are passively managed, fund managers don’t need to create complex investment strategies or actively trade stocks. This results in lower fund management costs compared to actively managed funds. Still, it’s important to compare expense ratios among different index funds, as even a small percentage can significantly impact your long-term returns.
3. Investment horizon
Index funds are best suited for investors with a long-term outlook, typically 7 years or more. Short-term fluctuations are common, but over time, these funds tend to smooth out and deliver consistent returns. If you have long-term financial goals, such as retirement or child education, index funds can provide returns in the range of 10-12% when held over an extended period.
Who Should Invest in Index Funds?
Index funds offer a good option for investors looking for a simple, low-maintenance way to invest in equities. They are mostly suitable for those who prefer not to track fund performance constantly or rely on fund managers to make investment decisions.
Investors who don’t want to track performance continuously
Actively managed funds require regular monitoring, as their performance can vary significantly due to market conditions or poor stock selection. Some actively managed funds may even underperform the market. Index funds eliminate this need for constant tracking since they mirror the performance of a specific index. Once invested, you don’t need to worry about individual stock selections or fund manager decisions. The fund’s returns will closely follow the index, making it relatively easier to invest and forget.
Investors content with market-level returns
If you’re happy with the returns the overall market generates and don’t wish to take additional risks for potentially higher returns, index funds can be a suitable option. Since these funds replicate a market index, they deliver returns that are in line with the overall market. While actively managed funds aim to outperform, index funds provide what’s known as market-level returns, which are generally more stable and predictable.
Investors who want to avoid human bias
Every fund manager has their own set of beliefs and strategies, which can sometimes lead to biassed decision-making. This human factor can affect the performance of an actively managed fund. Index funds remove human bias entirely since they follow a specific index based on preset rules. The fund manager’s role is limited to replicating the index, allowing investors to avoid subjective decision-making.
Taxability of Index Funds
The 2024 budget introduced changes to the capital gains tax structure for equity investments, including index mutual funds. Starting from July 23, 2024, the tax rate on long-term capital gains (LTCG) from index mutual funds has increased from 10% to 12.5%.
In addition, the short-term capital gains (STCG) tax on index mutual funds has been revised, rising from 15% to 20%. These changes aim to adjust the taxation of equity investments.
How to invest in Index Funds ?
Investing in Index Funds is hassle-free through your Angel One account. You just have to follow these steps:
Step 1: Log in to your Angel One account using your registered mobile number. Validate the OTP and finally enter your MPIN.
Note: If you do not have a Demat account with Angel One, you can open one in a few minutes by fulfilling the KYC procedure and submitting the necessary documents.
Step 2: Determine the most-suited fund based on your needs and risk profile. You can evaluate each fund under the mutual fund section on the Angel One app. Things to consider at this stage are:
Search for the fund you want to invest in or take cues from funds listed by Angel One across categories.
Analyse the fund’s past performance, tax incidence, constituent sectors and stocks.
Calculate the potential returns using the calculator.
Evaluate the fund’s level of risk and weigh it against your risk tolerance.
Check the fund’s ratings given by reputed rating agencies. Generally, the ratings range from 1 to 5.
Consider the fund’s expense ratio to get an idea about the cost of investing in it.
Step 3: Once you finalise the fund(s) you want to invest in, open your Angel One account, go to the Mutual Funds section, and look for it. Since this can be a long-term investment, be careful when choosing the fund that you would like to invest in. At this stage, consider the following:
Decide whether you want to invest in a lump sum or via monthly SIP
Next, enter the amount you want to invest and choose how you want to make the payment. UPI is the preferred mode. Alternatively, you can choose net banking.
After placing the order, in the case of the SIP route of investment, you can create a mandate to make hassle-free future instalments.
With a fund size of ₹12,590.85 crore, this small-cap fund focuses on investing in emerging companies with high growth potential. It has delivered a 3-year return of 23.26%, reflecting strong performance in the small-cap segment. The low expense ratio of 0.44% enhances net returns for investors, making it an attractive option for growth-oriented portfolios.
Motilal Oswal Nifty Smallcap 250 Index Fund Direct – Growth
This index fund, managing ₹828.81 crore, tracks the Nifty Smallcap 250 Index, which includes a diverse range of small-cap stocks. It has achieved a 3-year return of 23.13% while maintaining a competitive expense ratio of 0.36%. This combination makes it a cost-effective choice for investors looking to capitalise on small-cap growth.
Nippon India Nifty Smallcap 250 Index Fund Direct – Growth
This fund, with ₹1,873.67 crore in assets, also tracks the Nifty Smallcap 250 Index, aiming to provide investors with exposure to a broad spectrum of small-cap stocks. It has produced a 3-year return of 22.98% and features a low expense ratio of 0.35%, making it a viable option for growth-focused investors.
Canara Robeco Value Fund Direct – Growth
With assets totaling ₹1,342.26 crore, this value fund aims to invest in undervalued stocks with long-term growth potential. It has delivered a 3-year return of 22.86%, demonstrating its effectiveness in identifying profitable investment opportunities. The expense ratio of 0.59% remains competitive, offering value-oriented investors a solid option.
Aditya Birla Sun Life Nifty Midcap 150 Index Fund Direct – Growth
This mid-cap index fund manages ₹293.07 crore and tracks the Nifty Midcap 150 Index, focusing on medium-sized companies with strong growth prospects. It has achieved a 3-year return of 22.77% while maintaining an expense ratio of 0.44%. This fund is suitable for investors looking to diversify their portfolios with mid-cap investments.
Index funds usually mirror the performance of an index. Hence, they do see drops in times of crisis in the sector or the economy.
Should I invest in index funds?
Index funds offer a good opportunity to diversify your portfolio, allowing a portion of your corpus of funds to be invested rather passively.
What are the expected returns of index funds?
There is no particular expected return of index funds in general, as their performance depends on the index that they are tracking. So, an index tracking small-cap stocks may have a vastly different expected return from an index fund tracking a sectoral index.
What are the risks involved in investing in index funds?
The primary risk involved in index funds is market risk i.e. the risk of a fall in the share prices of the stocks it follows. Such a situation often arises not just during minor ups and downs but also during economy-wide recessions.
Are index funds taxable?
The income from index funds is taxable - however, the stage at which it is taxed and the taxable amount vary based on the time of withdrawal and the tax bracket of the investor.
How much money should I invest in index funds?
The exact amount of investment in index funds depends on the total corpus of funds you plan on investing into stocks/FDs/Mutual funds and the level of risk that you are willing to take.
What is the best index fund to invest in?
The best index fund depends on your financial goals, risk tolerance, and the market index you want to track. Popular choices include funds that track the NIFTY 50 or Sensex, offering broad market exposure.
Do index funds pay dividends?
Yes, index funds may pay dividends if the underlying stocks in the index distribute dividends. You can either receive them as payouts or have them reinvested in the fund.
Should I invest in individual stocks or index funds?
Index funds offer diversification and lower risk compared to individual stocks, making them a comparatively safer option for long-term investors. However, if you're prepared to assume greater risk and actively manage your portfolio, individual stocks may offer larger potential profits.
How long should I stay invested in an Index Fund?
Index funds are best suited for long-term investments, typically 7 years or more. Staying invested for this period helps you benefit from market growth and smooth out short-term fluctuations.
