Learn about Index Funds

As per SEBI’s scheme categorisation 2017, Index funds are mutual funds that aim to replicate and track a specific market index. Their primary objective is not to outperform the market but to mirror its performance. Since there is no active security selection in index mutual funds, the effort required for fund management and research is much lower in index funds compared to actively managed mutual fund schemes. As a resultthe Total Expense Ratio (TER) or the cost of managing the fund is usually much lower than that of actively managed mutual funds. Index funds give you a straightforward, cost-efficient way to start your investment journey. You do not have to analyze and compare performances of different schemes. All you have to do is select the market index where you would like to invest and select funds with low TER and low tracking errors.

Index funds also appeal to investors who believe in the Efficient Market Hypothesis. According to Efficient Market Hypothesis all publicly available information is already accounted for in the prices of the stock. The counter-argument to Efficient Market Hypothesis is that available data suggests actively managed mutual funds are able to create alphas (beat the benchmark market index) across different fund categories. Therefore, as far as our market is concerned, investors should have a mix of active and index funds in their investment portfolios based on their investment needs.

Index funds are mutual fund schemes which track a market benchmark index like Sensex, Nifty etc. They invest in a basket of securities which replicate the benchmark index they are tracking. Instead of active stock selection backed by extensive research, these funds replicate the portfolio of a particular index. Each stock in the portfolio of an index fund has the same weight that it is has in the benchmark index. This ensures that the fund's performance aligned with the index's performance subject to tracking errors. For example, the Nifty 50 Index fund will replicate the Nifty 50 Index. The fund will have exposure to the same set of stocks in a similar proportion. For example, if a stock constitutes 5% of the Nifty 50 index, the fund will allocate 5% of its assets to that stock. Any deviation in the proportion will result in the fund’s performance deviating from the index performance.

Index funds are suitable for wide range of investors. Investors who prefer a passive investment strategy and are content with market-matching returns will have more of their investments in these funds.Investors who prefer active fund management mayalsoinvest in index funds for investment-style diversification;they may allocate a small proportion to index funds. New investors, who might not have the expertise or time to delve into stock-specific or fund research, may find index funds suitable for their investment needs.

Factors to consider before investing in Index Funds

Here are some factors to consider before investing in index mutual funds:

• Your investment horizon: How long you plan to remain invested before you need funds for investment goal. This is a crucial factor as the answer to this question will allow you to decide on the asset class you would be investing in. As a thumb rule, if your investment horizon is more than five years, then you may consider equities as an asset class and invest in equity index funds (e.g. Nifty 50 index funds, Bank Nifty index funds etc). If your investment horizon is less than two or three years, then debt index fundscan be suitable investment options.
• Your risk appetite: The prices of securities change daily, as a result, the NAVs of your index mutual funds and your investment value can go up and down. This is referred to as volatility or risk. How much risk are you comfortable taking? Your risk appetite depends on a number of factors like your age, assets / liabilities, your investment experience etc. You should always invest according to your risk appetite. You should consult with your financial advisor or mutual fund distributor if you need help in understanding your risk appetite. Different asset classes have different risk profiles e.g. equity has higher risk profile than debt. You should invest in the suitable asset class and fund according to your risk appetite.
• The fees charged by the fund (TER):Index funds typically have lower TERs compared to active funds, but different index funds may have different TERs. You should compare TERs of different funds of the same asset class / sub-categories and select funds with lower TER. An index fund with lower TER is likely to outperform an index fund with higher TER tracking the same benchmark index.
• Tracking differences and errors: Tracking difference is the difference between the fund and index returns over different investment periods e.g. 1 year, 3 years, 5 years etc. Tracking error is defined as the annualized standard deviation of the differences in monthly returns of the fund and the benchmark. Tracking difference or error can be caused by a number of factors, like Total Expense Ratios, impact of circuit filters imposed by stock exchanges on portfolio rebalancing and cash holdings of the fund. You should invest in index funds with low tracking errors or differences.

Features of Index Funds

• Low fees: Index funds typically have very low fees compared to active funds. The low fees help in compounding over time.
• Diversification: Index funds invest in a wide range of securities, which helps to reduce risk.
• Transparency: Index funds are very transparent, as investors are always aware aboutthe securities in the fund (same as the index).
• Liquidity: Index funds are typically very liquid, as investors can buy and redeem with the Asset Management Companies (AMC).
• Convenience: Index fundsare like any other open-ended mutual fund schemes. You do not need to have Demat accounts to invest in index funds. You can buy and redeem with the AMC, either directly or through your mutual fund distributor. You can invest in index funds from your regular savings through Systematic Investment Plans (SIPs).

• Broad Market-Based Index Funds: These try to replicate a large segment (across market capitalizations) or a wide range of the market and hence tend to portray the total performance of the stock market. A Nifty 500 based index fund is an example of this type.
• Market Capitalization-Based Index Funds: A market capitalization-based index fund gives higher weightage to stocks with a higher market capitalization. Indices such as Sensex or Nifty 50 are market-cap weighted.
• Equal Weight Index Funds: In an equal-weighted index fund, every stock in the Index will have the same weight. For instance, if the underlying Index is Nifty 50, all the 50 companies in the corresponding equal-weight Index fund will have an equal weightage at approx. 2%.
• International Index Funds: These funds offer investing opportunities in stocks of companies listed outside of India, providing investors exposure to global markets. These can track multiple US-specific indices like S&P 500, NASDAQ, NYSE FANG+ Index, among others.
• Factor-Based or Smart beta Index Funds: These index funds apply certain filters or selection criteria (known as factors) on top of an underlying index to filter the better companies from the worse ones with the aim of outperforming the underlying vanilla index.
• Debt Index Funds: A debt index fund is based on an index comprising only corporate debt securities or government debt securities, meant for those whose goal is less to do with growing wealth but more to do with beating bank savings or deposit rates and earning more tax-efficient returns.

Taxability of Index Funds

Index funds that invest in stocks are treated as equity funds for taxation. Short-term capital gains (for holdings less than one year) from these funds are taxed at 15%. Long-term capital gains for holdings exceeding one year, are exempt up to ₹1 lakh and are taxed at 10% thereafter. Dividends from these funds are added to the investor's income and taxed according to their income tax slab.Index funds that invest in debt securities, here, the capital gainsand dividends are taxedas per your tax slab,i.e.the same is added to your income under respective sections, and then you are taxed as per the tax slab.

Advantages of Index Mutual Funds

• The biggest advantage of index funds is lower cost (TERs) compared to actively managed mutual funds. For the same level of performance of the underlying portfolio, lower costs means higher returns for investors.
• Actively managed funds aim to beat the market benchmark index. In order to beat the market index, they need to be overweight / underweight on some stocks / sectors. This gives rise to unsystematic risk i.e. stock or sector specific risk in actively managed funds.
• There is no unsystematic risk in index funds because they invest in the entire basket of stocks in the index they are tracking, in the same proportion as the market index. Index funds are only exposed to market risks.
• Fund managers are human beings and can have biases. There is no fund manager bias in index funds since index funds invest in the market index.
• You can invest in index funds from your regular savings through SIPs. By investing in index funds through SIPs, you can start early, invest over long horizons and benefit from the power of compounding. SIPs also help you remain disciplined and avoid making impulsive decisions based on market movements.