Index Fund – Definition, Benefits, Taxation & How to Invest in Index Funds

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08 min read.

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. Let us explore index funds in detail through the following topics.

What is an Index Fund?

Many investors are aware of the benefits of diversifying their portfolio across sectors. 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. The low expense ratio is its main USP.

Index funds are not actively managed funds, thus incurs low expenses. They do not aim at outperforming the market, but instead to track an index. They help an investor manage or balance the risks in their investment portfolio.

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.

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 expect predictable returns. These funds do not require extensive tracking. For example, if you wish to participate in equities but don’t wish to take 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.

The returns of index funds may match the returns of actively managed funds in the short run. However, the actively managed fund tends to perform better in the long term. Investing in these funds is suitable for long-term investors who have an investment horizon of at least 7 years. These funds do carry market and volatility risks and hence suits only those willing to take some risk.

Index Funds – Things to Consider as an Investor

  • Risk tolerance
    Since index funds map an index, they are less prone to equity-related volatility and risks. Investing in index funds is an excellent option if you wish to generate high returns amid a rallying market. However, you will have to switch to actively managed funds during a market slump. Index funds tend to lose their value during a market downturn. Hence, it is advised to have a mix of actively managed funds and index funds in your portfolio.
  • Return factor
    Unlike actively managed funds, index funds track the performance of the underlying benchmark passively. These funds do not aim to beat the benchmark but just to replicate the performance of the index. However, the returns generated may not be at par with that of the index due to tracking errors. There can be deviations from actual index returns.
    Hence, it is advised to shortlist funds with minimum tracking error before investing in an index fund. The lower the errors, the better the performance of the fund.
  • Cost of investment
    Index funds usually have an expense ratio much lower than actively managed funds. The portfolio of the index funds are generally passively managed, and the fund manager is not required to formulate any investment strategy. Hence, the difference in the expense ratio.
    If two index funds are tracking the Nifty, both will generate similar returns. The only difference will be the expense ratio. The fund, which has a lower expense ratio will generate comparatively higher returns on investment.
  • Investment horizon
    Index funds, generally, suits individuals with a long-term investment horizon. Usually, the fund experiences many fluctuations during the short run, which averages out in the long run, say, more than seven years to generate returns in the range of 10%-12%. Those who choose index funds must be patient enough to stick around for at least that long. Only then can the fund perform at its full potential.
  • 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 retire early and pursue your passion in life.

How to Invest in Index Funds?

It is easier to invest in index funds more than ever – with paperless documentation and hassle-free procedure. Yes, we have summed up the investment journey through ClearTax through the following steps.

  • Step 1: Sign in to
  • Step 2: Enter the 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 favourite index fund from amongst the hand-picked mutual funds

Taxation of Index Funds

As index funds are a class of equity funds, they are essentially taxed like any other equity fund plan. The dividends offered by an index fund is added to your overall income and taxed at your income tax slab rate. This is referred to as the classical method of taxing dividends in the hands of investors. The rate of taxation of index funds depends on the holding period. Short-term capital gains are realised on redeeming your units within a holding period of one year. These gains are taxed at a flat rate of 15%. Long-term capital gains are those gains that are realised on selling your fund units after a holding period of one year. These gains of up to Rs 1 lakh a year are made tax-exempt. Any gains above this limit attract a tax at the rate of 10%, and indexation is not allowed.

Top 5 Index Funds in India

While selecting a fund, you need to analyse the fund from different angles. There are various quantitative and qualitative parameters to determine the best index funds as per your requirements. Additionally, it would be best if you keep your financial goals, risk appetite and investment horizon in mind. The following table represents the top five index funds in India, based on the past three-year returns. Investors may choose the funds based on a different investment horizon like 5 years or 10 years returns. You may include other criteria like financial ratios as well.

Fund Name
ICICI Prudential NV20 ETF
Motilal Oswal NASDAQ 100 ETF
SBI ETF Nifty Next 50
UTI Sensex ETF

*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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