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An index fund is a mutual fund that imitates the portfolio of an index. These funds are also known as index-tied or index-tracked mutual funds.

This article covers the following:

  1. How do Index Funds work?
  2. Who should invest in Index Funds?
  3. Things to consider as an investor
  4. How to invest in Index Funds?
  5. Top 5 Index Funds in India

 

1. 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 exact 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. The popular indices in India are stock indices like BSE Sensex and NSE Nifty. Since index funds track a particular index, they fall under passive fund management. In this, 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.

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, sometimes there can be a small difference between the fund performance and the index. It’s known as the tracking error. The fund manager will try to reduce the tracking error as much as possible.

 

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2. Who should invest in Index Funds?

The investment decision in a mutual fund solely depends upon your risk preferences and investment goals. Index funds are ideal for investors who are risk-averse and want predictable returns. These funds do not require extensive tracking. For example, if you wish to participate in equities but don’t wish to take the risks associated with actively-managed equity funds, you can choose a Sensex or Nifty index fund. These funds will give you returns matching the upside that the particular index sees. However, if you wish to earn market-beating returns, then you can opt for actively-managed funds.

While the returns of index funds may match the returns of  actively-managed funds in the short run, however, over longer time periods, the latter tend to do better.
 

3. Things to consider as an Investor

 

a. Risk

As discussed earlier, since index funds map an index, they are less prone to equity-related volatility and risks. Index funds are amazing options during a market rally to earn great returns. However, you need to switch to actively-managed funds during a slump. It’s because index funds may lose higher value during a market downturn. It’s always advisable to have a mix of actively-managed funds and index funds in your portfolio.

 

b. Return

Unlike actively-managed funds, Index funds track the performance of the underlying benchmark in a passive manner. These funds do not aim to beat the benchmark but to just replicate the performance of the index. However, many a times, the fund returns may not match that of the index on account of tracking error. There might be deviations from actual index returns. Before investing in an index fund, you need to shortlist a fund which has the minimum tracking error. The lower the number of errors, the better is going to be performance of the fund.
 

c. Cost

Index funds usually have an expense ratio of 0.5% or even less. In comparison, actively-managed funds have an expense ratio of 1% to 2.5%. The reason being that the portfolio of the index funds is not passively managed and the fund manager need not formulate any investment strategy. The real differentiating factor between two index funds will be their expense ratio. If two index funds are tracking the Nifty, both of them will deliver largely similar returns. The only difference will be the expense ratio. The fund having a lower expense ratio will give marginally higher returns.
 
Index funds
 

d. Investment Horizon

Index funds are basically suitable for individuals who have a long-term investment horizon. Usually, the fund experiences a lot of fluctuations during the short-run which averages out in the long-run of say more than 7 years in order to give returns in the range of 10%-12%. Those who choose index funds need to be prepared to stick around at least for the said period to enable the fund to realise its full potential.
 

e. Financial Goals

Equity funds can be ideal for achieving long-term financial goals like wealth creation or retirement planning. Being a high risk-high return haven, these funds are  capable of generating enough wealth which may help you to retire early and pursue your passion in life.
 

f. Tax on Gains

When you redeem units of index funds, you earn capital gains. These capital gains are taxable in your hands. The rate of taxation depends on how long you stayed invested in index funds; such a period is called the holding period. Capital gains earned on the holding period of up to one year are called short-term capital gains (STCG). STCG are taxed at the rate of 15%. Conversely, capital gains made on holding period of more than 1 year are called long-term capital gains (LTCG).  Owing to recent changes in budget 2018, LTCG in excess of Rs 1 lakh will be taxed at 10% without the benefit of indexation.
 

4. How to Invest in Index Funds?

Investing in Index Funds is made paperless and hassle-free at ClearTax.

Using the following steps, you can start your investment journey:

Step 1: Sign in at cleartax.in
Step 2: Enter your personal details regarding the amount of investment and period of investment
Step 3: Get your e-KYC done in less than 5 minutes
Step 4: Invest in your favorite index fund from amongst the hand-picked mutual funds
 

5. Top 5 Index Funds in India

While selecting a fund, you need to analyze the fund from different angles. There are various quantitative and qualitative parameters which can be used to arrive at the best index funds as per your requirements. Additionally, you need to keep your financial goals, risk appetite and investment horizon in mind.

The following table represents the top 5 index funds in India based on the past 5 year returns. Investors may choose the funds based on a different investment horizon like 3 years or 10 years returns. You may include other criteria like financial ratios as well.

Fund Name1 year3 year5 year
UTI Nifty Index Fund16.69 10.4613.41
IDFC Nifty Fund16.57 10.4013.54
HDFC Index Fund16.59 10.4113.59
Aditya Birla SL Index Fund15.28 9.35 12.68
Franklin India Index Fund15.16 9.58 12.77

*The order of funds doesn’t suggest any recommendations. Investors may choose the funds as per their goals. Returns are subject to change.
 

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