What are Index Funds?

Index funds are becoming increasingly popular in India due to their superior returns and long-term wealth creation. When it comes to investing, today almost everyone opts for mutual funds. Now, we all know that there are different types of mutual funds available in the market.

But, index funds are the most preferred ones. Index mutual funds can help you accomplish your diversification goals. Here, in this article, we will cover the meaning of index mutual fund, their benefits, types, and a lot more.

Understanding Index Funds

Index funds are a type of mutual fund that tracks a market index like Sensex or Nifty. Index funds are passively managed, which means that the fund manager invests in the same assets as those found in the underlying index. Hence, the returns of the fund are similar to those of the particular index. These funds buy each stock in the same proportion as it appears in a specific index. They just try to replicate the index performance.

How do Index funds work?

There are two types of management styles in mutual funds: active management and passive management. In an active management style, the fund manager continuously shifts between stocks of various companies to increase profits for the investors and aims to outperform the market benchmark.

However, in the passive management style fund manager tries to equal the returns that the underlying index offers. So, Index funds aim to mirror the performance and composition of the index they are tracking. There may occasionally be a slight discrepancy in returns between the fund performance and the index. It is known as a tracking error. The fund manager will make every possible effort to minimize tracking errors.

Benefits of investing in index funds:

1. Low expenses: The minimal costs associated with index mutual funds are one of its main benefits. There is no requirement for a productive team of research analysts to assist fund managers in selecting the ideal companies because an index fund replicates its underlying benchmark. All of these elements contribute to an index fund’s low management
2. Easier to manage: Index funds are simpler to manage since fund managers don’t have to worry about how the index’s stocks are performing in the market. Simple portfolio rebalancing is all that is required of a fund
3. Tax advantage: Unlike actively managed mutual funds, index funds don’t buy and sell individual securities as frequently because they are passively managed. Therefore, their tax obligations are decreased, which eventually raises your post-tax
4. Extensive market exposure: Stocks in an index fund are usually well diversified, covering majorly all sectors and With just one index fund, an investor can profit from the likely gains on the bigger market segment.

Limitations of Index Funds:

1. Tracking error risk: The risk of tracking mistakes still exists even though index funds are free from fund management Due to liquidity restrictions, changes in index constituents, corporate actions, etc., tracking errors may happen in an index fund.
2. Restricted to large-caps: Index funds provide decent exposure to large-cap securities, but there aren’t many indices that provide exposure to small- and mid-cap securities. In this instance, actively managed small, medium, and multi-cap funds outperformed index funds by a significant
3. No flexibility: There is no flexibility for fund managers to handle the market If there is a market downside or unfavorable economic conditions, the fund manager can deal with the situation by making changes in the allocation. However, an index fund must adhere to the benchmark, no matter if the market goes upwards or downwards.

Who should invest in Index funds?

Whenever you buy any mutual funds, the first thing you should consider is your risk tolerance and financial goals. These funds are preferred by investors who wish to invest in the equity markets but seek predictable returns and low risk. One of the benefits of index funds is that you do not need to closely monitor these funds all the time. These funds offer you decent returns that are in line with the growth of that specific index. The best choice for investors looking for greater returns is actively managed equity funds.

Here are the factors to Take into Account Before Investing in Index Funds:

1. Financial objectives: Index funds might be a smart choice if you’re trying to make a long-term But if you lack the time or the patience to wait through market changes, buying individual stocks can be a better option for you. Index funds are best suited for individuals who have financial goals for longer tenure like retirement or child education, etc.
2. Risk tolerance: Before choosing an investment, you should also think about how much risk you can Each investment carries a different amount of risk. Some are less risky than others, offering lower returns, while others offer greater potential upside but also greater volatility over time. Since index funds are passively managed, the risks are not very high as compared to actively managed funds.
3. Time Horizon: Another factor is to know your investment If your goals are for the short term then you may choose investment in debt funds or liquid funds. However, if you have a long-term goal, then an index fund is a good option.
4. Returns: Index funds only seek to mimic the index’s performance, not to outperform the High tracking errors that may reduce your returns. Therefore, before investing in an index fund, choosing funds with the lowest tracking error is advisable. The performance of the fund is improved by fewer errors.
5. Expense ratio: It is the amount the fund management charges for its services. It is expressed in terms of the percentage of the fund’s total assets. The main benefit of index funds is that they have a slightly lower expense ratio than actively managed funds, which is a good

Taxability of Index Funds:

Index fund redemptions is subject to capital gains tax. Additionally, the holding term of the fund’s unit units affects the tax rate.

• Short-term Capital Gain Tax: STCG arises when the units are held for less than a year/ 12 The tax rate is 15%
• Long-term Capital Gain tax: LTCG arises when units are held for more than a year/12 LTCG under Rs. 1 lakh is not subject to tax. Any LTCG that exceeds this cap is subject to a 10% tax rate without indexation benefits.

Top Performing Index Funds in India:

S. No	Top Index Funds	AUM (Rs. in cr.)	3-year returns	5-year returns
1.	UTI Nifty 50 Index Fund	9502.80	16.45%	13.89%
2.	SBI Nifty Index Fund	3199.02	16.22%	13.67%
3.	HDFC Index Fund-S&P BSE Sensex	4214.10	16.00%	14.52%
4.	ICICI Prudential Nifty 50 Index Fund	3970.70	16.45%	13.76%
5.	HDFC Index Fund-NIFTY 50 Plan	7,551.40	16.33%	13.83%
6.	Nippon India Index Fund S&P BSE Sensex Plan	357.57	16.16%	14.60%
7.	ICICI Prudential Nifty Next 50 Index Fund	2609.51	15.65%	8.12%

Final Thoughts:

Index funds are the best option for investors looking for low-cost, stable returns and a diversified portfolio. What else do you need, right?

If you invest in mutual funds and want to grow your money but don’t want to do a lot of research, index funds are an excellent way to meet your different financial objectives. However, it is recommended to consider various factors like your risk appetite, goals, and return expectations before investing. Choose the mutual funds with the help of the best stock broker in India.

FAQs About Index Funds:

by Instockbroker Team | March 22, 2024