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Index Fund Meaning and Definition

Index mutual funds aim to replicate a financial market index closely. These funds invest in the same securities as the benchmark index and in the same ratio. For example, an index MF that aims to track the Nifty 50 index will invest across the same 50 companies in the same proportion. Thus, replicating the index performance. 

Since these funds replicate the underlying benchmark index, they are passively managed funds. The fund manager aims to replicate the index with minimum tracking error. Thus, the funds are free from any fund manager bias or decisions. Furthermore, as these funds are passively managed, the expense ratio is much lower in comparison to actively managed funds

Index MFs are a good investment to achieve diversification. Diverse stock composition is what makes a benchmark index. Thus, investing in an these fund will help you achieve higher diversification and generate benchmark returns, if not more.

Explore: Best Index Funds to Invest in 2023

Different Types of Index Funds

  • Broad Market Index Funds: The funds replicate a large section of the market. These funds tend to have a lower expense ratio and, at the same time, are tax efficient. These are popular among investors looking for a large variety of stock or bond exposure. 
  • Market Capitalization Index Funds: These funds mimic indexes based on their market cap. For example, market capitalization-based index MFs replicate the large-cap index, mid-cap index, and small-cap index. Here, a large portion of the funds is exposed to a particular market cap, large, mid or small-cap stocks. 
  • International Index Funds: These funds track and mimic the global indices. International index MFs give exposure to international markets and companies. Thus, allowing an investor to diversify across emerging markets and countries. 
  • Earnings-based Index Funds: These funds track indices based on their profit-generating capacity. They mimic growth and value indexes. The growth index comprises of companies that have a good potential to generate profits. On the other hand, the value index comprises of stocks that are currently trading at a lower value than their actual worth. 
  • Bond-based Index Funds: Bond-based index funds mimic the bond indices. These are comparatively low-risk investment options than equity index MFs. These funds invest across government and corporate bonds. Furthermore, they can have a defined maturity.

Points to Consider Before Investing in Index Funds

The following are the points to consider before investing in index MFs:

  • Investment Goals
    Index MFs are suitable for the long term. These schemes invest across equity instruments. Thus a long-term investment horizon will help in averaging out the market volatility. However, markets tend to be highly volatile in the short term. Thus the probability of generating higher growth can be low. Therefore, these funds are suitable for investors with a long-term investment horizon, i.e., a minimum of 5 years. 
  • Fund Risk
    Index MFs are market-linked instruments and thus are risky. These funds are less risky in comparison to actively managed funds. However, when the markets are in a slump, the fund’s performance may also fall. Thus, having only index funds in your portfolio may not be the ideal strategy. A combination of active and passive investments will help average the risks. 
  • Fund Returns
    These MFs aim to generate returns as close to the market index as possible. However, the tracking error plays a significant role in determining the investor’s returns. Tracking error is the variability in the index fund’s performance against its benchmark. It is also known as the standard deviation. Thus, it is good to pick funds with the least tracking error. 
  • Expense Ratio
    Since these funds are passively managed funds, their expense ratio is lower in comparison to actively managed funds. The expense ratio can be a deciding factor while shortlisting an index MF to invest. A lower expense ratio fund might have a greater potential to generate better growth for the investor. 
  • Tax on Mutual Fund
    Index funds taxation is similar to any mutual fund. Capital gains taxation varies depending on the type of fund, equity or debt. For equity mutual funds, the short-term capital gains (investment holding period less than one year) are taxable at 15%. The long-term capital gains (investment period more than one year) above INR 1,00,000 are subject to 10% tax. 
    On the other hand, for debt mutual funds, the short-term capital gains (holding period less than three years) are taxable as per the investor’s income tax slab rate. For long-term capital gains (holding period of more than three years), the gains are taxable at 20% with an indexation benefit. 

Advantages of Investing in Index Funds

  • Low Expense Ratio: One of the biggest advantages of index funds is that they have a low expense ratio. The expense ratio is the fees that the fund house charges investors for managing the fund. Since these MFs are passively managed, the expense ratio is lower, as the fund manager merely mimics the underlying index. 
  • No Fund Manager Bias: Since these are passively managed funds that mimic the benchmark index, the fund manager doesn’t have to spend time and energy picking the funds for the portfolio. In the case of actively managed funds, the fund manager’s analysis and decision-making largely impact the fund’s returns. However, that isn’t the case with these funds. Instead, the fund manager must simply mimic the benchmark with minimum tracking error. 
  • Broad Market Exposure: A benchmark comprises of stocks that represent the market/ sector as a whole. Investing in a fund that tracks the benchmarks gives exposure to a wide range of stocks that define the market movement as a whole. 
  • Easy to Manage: these are easy to manage for both the investor and the fund manager. Investors need not worry about tracking the performance of the fund and the fund manager. Since these fund replicates the benchmark, investors can expect returns close to the benchmark returns. 

Risks Associated with Index Funds

The following are the risks associated with index MFs:

  • Lower Flexibility: During a market slump, the fund manager doesn’t have the liberty to change the portfolio allocation to minimize the negative impact. Thus, these funds do not offer any flexibility to the fund manager. 
  • Underperformance: These funds are often at a high risk of underperforming the benchmark it is tracking. This is because of the higher trading costs, fees, expenses and tracking errors. 
  • Tracking Error: Another significant risk that index funds have is tracking error. Tracking error refers to the inaccuracy in tracking the underlying benchmark. 

Frequently Asked Questions

How does an index fund work?

Index MFs aim to replicate the portfolio composition of a benchmark index with minimum tracking error. These funds invest in the same securities and in the same proportion. Thus, they aim to generate benchmark returns for the investors. They try to maintain the same portfolio allocation as the underlying benchmark at any time.

Who should invest in index funds?

Investors who want to invest in passively managed funds and have a long-term investment horizon can consider investing in index funds. Furthermore, investors with low to medium risk tolerance levels can consider investing in these funds. In comparison to actively managed funds, index MFs have a lower risk. However, this doesn’t mean they guarantee returns.

Are the lowest expense ratio index funds the best?

Yes, index MFs with a low expense ratio and minimum tracking error are considered a good investment option. Such funds have the capacity to generate returns close to the benchmark.

Can you lose money in an index fund?

Yes. Index funds are market-linked investment options. Thus, you can lose money (not entirely, but have negative returns) while investing in an index fund. However, having a long-term investment tenure will help combat the market volatility and average the potential returns.

Do index funds pay dividends?

Most index funds do not pay dividends. The ones that pay haven’t been consistent with their payouts.

What are the expected returns of index funds?

Index funds attempt to replicate the underlying benchmark closely. Thus, you can expect returns close to that of the benchmark. However, an index fund with minimum tracking error can generate such close returns.

How long should I stay invested in an Index Fund?

Since index funds are equity-schemes, it is advisable to have a long-term perspective, say a minimum of 5 years. The long-term investment horizon will help you average out the market volatility and generate significant returns.

What are the advantages of index funds?

Historically, many actively managed funds have failed to outperform their benchmark. The biggest advantage of index funds is their ability to generate returns close to that of the underlying benchmark.

What are the disadvantages of index funds?

The main disadvantage of index funds is the ability of the fund manager. If the fund manager cannot replicate and maintain the same stock weightage as the underlying benchmark.