Index Funds are Mutual Funds that replicate an Index’s portfolio. Index funds are also called index-tracked and index-tied mutual funds since they imitate a particular index. 

What are Index Funds?

Index funds are the mutual funds that work on the traces of the benchmark fund or market. These funds imitate the performance of the underlying index be it Nifty or Sensex. Investors generally invest in index funds to diversify their portfolio across different fund types, indices and segments. The performance of index funds is ideally supposed to be the same as of the underlying index and they are mostly preferred by investors due to their low maintenance and lower expense ratio as compared to other funds. 

Since these funds are not actively managed, the maintenance cost of these funds is quite less. The main aim of index funds is not outperforming the benchmarks or underlying indices but to maintain a uniform pace of returns and stay at par with the respective index. Index funds are one of the first choices of investors when it comes to investing in such a fund that provides a balance against the risks involved. 

How are Index Funds traded?

The trading or working is index funds that are quite simple. For example, if you have invested in an index fund that replicates Nifty, then the portfolio of the index fund you are invested in will have the exact same stocks in it and in the exact same quantities. The Index Funds are either equity securities like stocks or bond securities. The most followed indices are BSE S&P Sensex and NSE Nifty 50. The index funds are passively managed and the portfolio constituents are decided by the fund manager depending upon the market situation and the funds the underlying index has invested in. 

The Index Fund works hard enough to match the performance of the underlying index and not outperform it. The Index Fund doesn’t need to deliver exactly the same returns as that of the underlying index. There may be slight variations in the returns delivered.  This gap is technically called a tracking error. It is the responsibility of the fund manager to reduce the tracking error as much as possible. 

Who should go for Investing in Index Funds?

Investing in any type of mutual fund depends majorly on your investment goals and risk profile. When it comes to index funds, these are best suited for investors who are looking for a mutual fund investment that is less risky and provides consistent and uniform returns. The returns generated from index funds are generally predictable in nature as they simply replicate the underlying index that also calls for low maintenance of the investment. If you wish to earn returns that are satisfactory across all levels and are not feeling really enthusiastic about earning highly, then index funds are a good option. 

However, if you want to be an aggressive earner then you can look for other fast-paced investment options that are a little higher on the risk side. These funds are generally actively managed by a dedicated fund manager along with his or her team of experts. 

Things to consider while investing in Index Fund

  • Risk profile

Before you make investments in index mutual funds or any other type of mutual fund, you must understand your risk profile. Since index funds simply imitate the underlying index, they are less prone to market fluctuations and volatility. Hence, index funds serve as an excellent form of investment for investors who are risk-averse and wish for an investment that provides consistent returns. However, index funds are not very attractive while the markets are soaring. Hence, it is better to have a mixed portfolio with a combination of funds diversified across different market segments.

  • Return Factor

The returns generated from index funds are highly predictable as they simply imitate the underlying index. The main aim of these funds is to simply replicate the returns generated by the underlying index and not outperform them. An investor may find a slight variation in the returns generated by index funds and the underlying index as there is always a tracking error that brings the deviation in the returns. Before you invest, you must look out for funds that have minimal tracking error.

  • Investment Cost

The investment cost associated with index funds is quite less as these are passively managed funds. The expense ratio associated with the index funds is 0.5% or less than this whereas, for actively managed funds, the expense ratio goes up to 2.5% even. The fund manager is not so actively involved in the index funds and this is why the maintenance cost is quite less.

  • Investment Horizon

If you are planning to invest in index funds, you must lookout for a long term investment. Index funds get highly affected by the market fluctuations and volatility and hence must be invested in for the long term to balance out the risks over the investment horizon. A minimum of five years is recommended to stay invested in index funds to realize the benefits of around 10%-12% CAGR.

  • Capital Gains Taxation

An Equity Oriented Mutual Fund that is held for less than 12 months is a Short-Term Capital Asset. The Short Term Capital Gains (STCG) tax for Equity oriented Mutual Funds is 15 percent on total gains earned. An Equity Oriented Mutual Fund that is held for more than 12 months is a Long-Term Capital Asset. The Long Term Capital Gains (LTCG) tax for Equity oriented Mutual Funds is 10 percent on gains above Rs. 1 Lakh.

What are the top 5 Index Funds in 2020 in India?

Following is a list of top 5 Index Funds you can invest in India in 2020:

  1. ICICI Prudential Nifty50 Fund – Direct Plan
  2. UTI Nifty Fund – Direct Plan
  3. HDFC Sensex Fund – Direct Plan
  4. UTI Nifty Next50 Fund – Direct Plan
  5. Nippon India Index Fund – Sensex Plan – Direct Plan

Happy Investing!