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What are index funds? Detailed guideline & analysis of investing in index funds in India

Index Funds

Index funds are mutual funds that have a portfolio constructed to match the index of the market. The returns from these mutual funds match that of the benchmark. These funds have low portfolio turnover, broad market exposure, and low expense ratio. These mutual funds replicate the portfolio of the benchmark, and hence these are also known as passive funds. Also, these funds are best for investors investing for the long term (10+ years) and for those who do not want to monitor their portfolio constantly.

What is a stock market index?

The stock market index is a measure to show the changes or movements in the stock market. An index is created to monitor the movements in the market. A similar type of security is clubbed together. The selection of securities is based on the type of industry, market share of each security, performance of the security in the market, etc. The examples of a stock market index are Sensex, Nifty 50, etc.

The value of the index is the value of the securities, which are clubbed in the stock index. Hence, the change in the value of the security has a direct impact on the value of the index.

What is an Index Fund?

An index fund is a type of mutual fund that replicates a stock market index. These funds replicate the composition of a benchmark and invest in the same securities and the amount as well.

For example, Sensex comprises three securities. 

Tech Mahindra Ltd – 30% of total Sensex value

Yes Bank Ltd – 40% of total Sensex value

Infosys Ltd – 30 % of total Sensex value

An index mutual fund will also invest in the above securities and in the same weight. Its portfolio will comprise of the following security

Tech Mahindra Ltd – 30% of total Sensex value

Yes Bank Ltd – 40% of total Sensex value

Infosys Ltd – 30 % of total Sensex value

Hence, by replicating the stock market index, these mutual funds aim to achieve the same returns as that of the benchmark.

How do Index Funds Work?

Index Funds track a particular index or benchmark. An index defines a market segment. In other words, securities that belong to the same segment are grouped and form an index. These segments are either equity-oriented instruments like stocks or bond market instruments. For example, an Index fund tracking NIFTY will have the same 50 stocks that NIFTY comprises off and in the same proportion. These funds track a particular benchmark, hence fall under the passively managed funds. The fund manager doesn’t pick the stocks and just mimics the benchmark. The fund management team aims to maintain the composition of the underlying benchmark.

Returns from these funds are more or less equal to that of the benchmark. However, there would be a slight difference in the performance and this is known as the tracking error. The best fund would be the one with the least tracking error. Also, these funds have a low expense ratio compared to actively managed funds. Also, all future inflows are invested in the same proportion of the underlying index.

Index Mutual Fund in India can be of two types Index Mutual Funds and Index Exchange Traded Funds. Index Mutual Fund is offered directly by the fund house. While Index Exchange Traded Funds are traded on the stock exchange.

Points to consider before investing

Investment Period

Index funds are suitable for investors who can stay invested in the fund for a longer period. Since these funds replicate a benchmark, it may go through many market fluctuations in the short term. These fluctuations will average out in the long term. 

Therefore, these funds may prove to be a good option for wealth creation and appreciation in the long term.

Cost of investment

Index funds are passively managed funds. Since an this fund is a proxy of a stock market index, the fund manager does not actively monitor the portfolio. Due to this reason, the cost of managing the fund is low. Hence the expense ratio of these funds is lower when compared to actively managed funds.

These passive funds will be charged 0.30% to 0.50% of the total fund, while any other actively managed fund will be charged 1% to 2% of the fund value.

Diversification of portfolio

Index funds are made up of securities that a benchmark holds for its portfolio. The portfolio of an index fund consists of securities of top companies from different sectors. Hence this diversification in the portfolio allows the investor to manage the risk of being overinvested in a particular security or sector.

Tax on index mutual fund in India

The redemption of units of index funds is taxable as a capital gain. Also, the tax rate depends on the holding period of the units of the fund.

Short Term Capital Gains

STCG arises when the period of holding of the units is less than 12 months. The tax rate is 15% on the amount of gain earned.

Long Term Capital Gains

LTCG arises when the period of holding of the units is more than 12 months. The tax rate is 10% without the benefit of indexation on the amount of gain earned.

Who should invest in an Index Fund?

Index funds aim to match the performance of a benchmark. A stock market index benefits an investor in the long term. Hence, these funds best suit investors who are looking to invest for the long term, ideally for retirement. These funds are also an ideal option for investors who prefer earning foreseeable returns. Considering these funds do not have a lot of risk in them, therefore is a perfect option for risk-averse investors looking for some equity exposure. Also, index funds are passively managed funds that do not require monitoring of the portfolio.

On the other hand, an actively managed fund’s portfolio is based on the fund manager’s predictions and involves an element of risk. Actively managed funds require continuous monitoring of the portfolio. Hence, index funds also suit investors who wish to invest and forget about the investment for a long time. The returns from index funds match that of the benchmark, and investors cannot expect higher returns than the benchmark. Hence, for investors looking for higher returns, actively managed funds can be preferred.

Best Index Mutual Funds in India

Diversified Index Funds 1-Year Return 3-Year Return 5-Year Return
UTI Nifty Index Fund -22.44% -0.46% 2.27%
HDFC Index Fund-NIFTY 50 Plan -22.64% -0.63% 2.15%

About the Best Index Funds India

UTI Nifty Index Fund

The principal investment objective of the scheme is to invest in stocks of companies comprising the Nifty 50 Index and endeavor to achieve return equivalent to Nifty 50 Index by “passive” investment. Moreover, this passively managed fund endeavors to minimize the return differential between the fund and the underlying benchmark.

Expense ratio: The fund charges 0.17% of the asset under management

Asset Under Management: INR 2,097.08 cr

The minimum SIP amount is INR 500

Minimum Lump sum amount is INR 5,000

HDFC Index Fund – NIFTY 50 Plan

The scheme is managed passively with investments in stocks in a proportion that is as close as possible to the weights of these stocks in the NIFTY 50 Index. The investment strategy revolves around reducing the tracking error to the least possible through regular rebalancing of the portfolio, taking into account the change in weights of stocks in the Index as well as the incremental collections/redemptions.

Expense ratio: The fund charges 0.30% of the asset under management

Asset Under Management: INR 1,461 cr

The minimum SIP amount is INR 500

Minimum Lump sum amount is INR 5,000

How to Invest in Index Funds?

Investing in index mutual funds in India can be done directly or through an agent. Investors can invest online through the direct method by logging on to the fund houses’ website and investing in the fund. On the other hand, they can invest through offline mode by visiting the nearest branch of the fund house. Investing through an intermediary can be done both online and offline.

There are multiple online platforms to invest in these funds, and one of them is Scripbox. Scripbox allows investors to invest the best funds carefully picked after thorough research using their robotic technology. You can invest in Scripbox recommended best index mutual funds in India by following the below-mentioned steps:

  1. Login to Scripbox
  2. Click on ‘ Let’s Get Started’
  3. Begin your investment journey with ‘Build Wealth.’
  4. Select the mode of investment i.e., monthly SIP, one time or STP
  5. Enter the amount of investment
  6. Based on the amount of investment, the recommended funds will be provided. You can change the funds and the distribution of the amount
  7. Select the payment mode and proceed toward the payment
Published on January 17, 2020