What is Index Fund, How They Work, Benefits and Risks

According to a recent survey, passive funds are gaining popularity in India with 63% of survey respondents being positive about passive investing, especially Gen Z and Millennials. Index funds simply mirror the performance of a specific index without any strategic stock picking. In this article, let us explore what are index funds and how you can allocate part of your investments to index funds.

What is Index Fund?

Index fund is a type of mutual fund designed to replicate the performance of a specific market index. Index funds are not managed actively and are known as passive funds because portfolio constitution and investment decisions do not depend on a fund manager’s skill.

An index fund aims to track the constituents of an index as a preset basket without changing its composition. There are different types of index funds in the market that track varied indices.

How do Index Funds Work?

If you invest in an index fund, your portfolio will have all the stocks constituting the index in the same proportion. For example, if you invest in Nifty 50 index fund, you will have all the 50 stocks that represent the top 50 companies in India, in the same composition as the Nifty 50 index. Or, if you decide to put your money in Nifty Midcap 150 index, you will have exposure to companies ranked 101-250 based on full market capitalisation.

On the contrary, in an actively managed mutual fund, fund managers employ their investment skills and experience to design a portfolio, they actively manage the corpus with frequent buying and selling securities as per fund's objective and aim to outperform the benchmark.

Index funds, on the other hand, aim to deliver the same returns as the index without deviating from the index composition and are not allowed to take any other discretionary investment decision or risk. 

Benefits of Investing in Index Funds

Index funds have the spotlight on them due to numerous benefits they offer to both novice and experienced investors.

• Diversification: The biggest advantage index funds offer is that your portfolio is automatically diversified in all the stocks comprising the index. As against buying stocks individually with your own research, index funds give you the opportunity to invest in top stocks from multiple sectors.

• Cost Efficient: Index funds being passively managed, incur lower costs compared to actively managed funds. Thus, the expense ratio of index funds is lower than actively managed funds which enhances the return to investors.

• Lower Risk: Index funds by definition invest in the index as a whole and do not target specific stocks, segments, or commodities. Therefore, the risk is also spread across a number of companies and segments, thus lowering the overall risk. On the other hand, individual stocks or specific sectors are prone to higher volatility.

• Long-Term Growth: Index funds mirror the broad indices which reflect the performance of a significant segment of stock market. Indices are an indirect gauge to assess how a country's economy has performed over the long term. Investing in index funds is akin to participating in growth of the markets and economy in general. 

• Convenient: Index funds are the simplest way to invest in stock markets without having to strategise a particular theme, sector or taking frequent trading decisions for optimum benefit. Index funds simplify stock market investing for new as well as experienced investors.

Popular Index Funds in India

Here’s a list of popular equity index funds in India:

Visit Rupeezy app for the best index funds mapping various indices and their performance across different time periods.

Risks of Index Funds

While there are benefits that index funds offer, there are risks associated as well with index fund investing, here are a few:

• Limited Upside Potential: Index funds strictly invest in specific index composition without any deviation. This limits any opportunity for growth over and above the index's performance.

• Missed Market Opportunities: Stocks, specific segments, and markets present opportunities to invest and make better profits in different market cycles. However, index funds are restricted to invest only in index portfolio, thereby limiting profits from such opportunities.

• Market Risks: While index funds offer diversification in stocks that form the index, investors are exposed to market risks as well without the freedom to change strategy.

• Passive Management: Mutual funds are attractive to investors since they are managed by professionals and experienced fund managers. Index funds do not have any active management by fund managers and depend solely on index performance.

How to Invest in Index Funds

Investing in Index funds is easy with Rupeezy app:

• Download the Rupeezy app and complete online KYC process and verification.

• Go to ‘Explore’ tab and search for specific fund.

• Alternatively, go to ‘Equity’ category and select ‘Equity Index Funds’.

• Evaluate the Risk-Return performance of all the Index Funds from various AMCs.

• Check ‘List View’ for fund-specific details for each fund such as Returns, Risk, AUM, Expense Ratio, Scheme Offer Document, Portfolio, etc.

• After selecting the fund, choose ‘One Time’ or ‘SIP’ mode of investment.

• Make payment via UPI or Net Banking.

• Units are allotted in your portfolio in 2-3 business days.

Taxation of Index Funds

Equity index funds are treated as equity-oriented mutual funds (holding >65% corpus in equity) for taxation purposes. Capital Gains or profits earned from selling mutual fund units are taxed as under:

STCG (Short Term Capital Gains) Tax: Capital gains from mutual fund units sold within one year of purchase are termed as short term capital gains.

STCG from index funds is taxed at the rate of 20%.

LTCG (Long Term Capital Gains) Tax: Capital gains from mutual fund units sold after one year of purchase are termed as long term capital gains.

LTCG from index funds is taxed at the rate of 12.5%. Capital Gains till Rs.1,25,000 in a financial year are exempt from LTCG tax. Any long term capital gain above Rs.1,25,000 in a financial year is liable for LTCG tax.

Debt index funds (with >65% holding in debt securities) are treated as debt funds for tax purposes.

Capital gains from debt index funds are treated as income and taxed as per investor’s income tax slab rate (for all investments done on and after 1st April 2023).

How to Choose the Right Index Fund

Index fund is a broad category under the mutual fund umbrella. Here are a few points to consider to choose the index fund suitable for your portfolio:

• Expense Ratio: Expense ratio directly impacts your overall return. Since index funds are passively managed, a scheme with a lower expense ratio is beneficial.

• AUM: Consider the size of the fund. A large AUM (Asset Under Management) shows investor confidence, it also benefits investors with lower operational costs due to economies of scale. 

• Tracking Error: Tracking Error of an index fund measures how much a fund has deviated from the index returns. A low tracking error indicates fund returns closely match the index returns.

• Investment Goals: It is important to understand one’s financial goals as equity index funds are stock market investments and require a long time horizon to deliver returns.

• Risk Appetite: Assess your risk tolerance as index funds are impacted by market volatility, even though they might be more stable or less risky than actively managed equity funds.

• Index Type: There are different types of indices that index funds track. All index funds are not the same, it is important to understand the composition of the underlying index before investing. Broad diversified indices such as Nifty 50 or BSE Sensex are less volatile than sector specific indices or small cap or mid cap indices.

Conclusion

To conclude, index funds are a viable investment tool for investors looking to invest in diversified stocks from reputed companies across sectors at low cost and minimal intervention or individual fund manager’s strategy. Invest in top performing index funds from top AMCs with Rupeezy. Build a hypothetical portfolio and back-test your portfolio mix, check overlap with other funds and much more, only on Rupeezy.

FAQs

Q. What is Nifty 50 index fund?

Nifty 50 index fund tracks the performance of top 50 stocks on NSE (National Stock Exchange).

Q. What is index mutual fund?

Index mutual fund is a type of mutual fund that mirrors a specific index and invests in stocks in the same composition as the index.

Q. What is S&P 500 index fund?

S&P 500 is a stock market index that tracks the market performance of the top 500 companies listed on stock exchanges in the United States.

Q. What is momentum index fund?

Momentum Index Fund is a type of index fund that tracks the performance of top 50 stocks from a broader index, selected based on their momentum or upward price movement.

Q. What is equal weight index fund?

An equal-weighted index fund is an index fund that allocates money equally to each stock in the specific index irrespective of the market cap or size of the company.