What is An Index Fund? [A Beginner Friendly Guide]

Index funds have emerged as a popular investment choice in India due to their lower management cost and consistent performance in the long term.

If you are unfamiliar with index fund investments, reading this valuable resource is going to be essential & useful for you. So, let’s start without any unnecessary boasting.

Index Funds: Meaning & Explanation

An index fund or index mutual fund is an identical portfolio of stocks that tracks a specific stock market index such as the Nifty or the Sensex in the case of India.

For example, a Nifty 50 Index Fund closely mirrors all of the stocks included in the Nifty 50 index in their respective weightage. However, some equal-weight index funds allocate equal weights to all stocks in the index

Note: Nifty 50 Index includes the 50 largest and most liquid companies listed on the National Stock Exchange of India (NSE).

An index fund aims to deliver similar returns as the index with minimum effort. In other words, they are designed to replicate the performance of the chosen index.

How Index Funds Work

Unlike an actively managed mutual fund, index fund managers do not have to worry about researching and picking specific stocks.

They need to pool money from investors and invest it in the replica of the portfolio for the chosen index. After that, they only need to rebalance the portfolio periodically or if required.

Related Read: Know Everything About smallcase Investing (Portfolio Investing)

Types Of Index Funds

There are various types of index funds available to investors, each designed to track a specific segment of the market. Here are popular types of Index funds:

1. Market Index Funds: These funds aim to replicate a market index such as S&P 500, Nifty 50 Index, Nifty Next 50 Index, Sensex Index etc.
2. Sectoral Index Funds: These funds are focused on replicating any specific sector index such as banking, finance, technology, etc. For Example, Bank Nifty Index focuses on the banking sector.
3. International Or Global Index Funds: International Index funds focus on international indexes outside of the investor’s home country.
4. Real Estate Index Funds: These funds track indexes that represent the performance of real estate investment trusts.
5. Debt Index Funds: These funds track the performance of fixed-income or debt securities such as government bonds, corporate bonds or a composite bond index.

It is to be noted that some of the types of Index funds may not be available in the Indian Market. Here is a list of some common & popular types of Index funds in India:

1. Nifty 50 Index Funds
2. Nifty Next 50 Index Funds
3. Nifty Mid Cap Index Funds
4. Nifty Small Cap Index Funds
5. Sensex Index Funds
6. Bank Nifty Index Funds
7. Banking and Financial Services Index Funds
8. Technology Index Funds
9. IT Index Funds
10. Pharma Index Funds
11. Debt Index Funds etc.
12. More NSE Index Funds.

Advantages Of Investing In Index Funds

Index funds are popular investment choices among investors due to the advantages they offer. Below is a list of some advantages:

A. Low Fees: Index funds use passive investing which offers lower management costs (expense ratio) than other actively managed mutual funds. For a general example, index funds charge an expense ratio of 0.1 to 0.5% while actively managed funds cost 1 to 2.5%.

B. Diversification: Index funds offer good diversity by investing in a wide range of securities that make up the underlying index. It reduces the risk associated with investing in individual securities.

C. Transparency: Index funds disclose their holdings regularly providing transparency to investors while other mutual funds may not fully transparent.

D. Availability: Index funds are widely available & accessible to investors with or without extensive knowledge or expertise.

Disadvantages Of Investing In Index Funds

While index funds have numerous advantages, it’s important to be aware of their potential disadvantages as well. Read on to know.

A. Missing Out Opportunities: Index funds may miss out on the potential benefits of certain market opportunities because they do not have the flexibility to select specific securities to invest in.

B. Tracking Error: Accurate tracking of an index is not possible due to some factors such as timing differences between the index and the fund’s rebalancing, transaction costs etc. This is the second disadvantage of Index funds.

C. Volatility: Sometimes index funds show more volatility if compared to some other actively managed funds in the short term.

D. Uncertain Returns: Index funds do not promise stable returns. Sometimes it may provide you with higher than any other funds while other times it may perform the opposite providing you lower returns in the short term.

Index Funds Vs Other Mutual Funds

If you have reached here in the post, probably you know the difference between index funds & other mutual funds. By the way, here is a table providing a brief comparison between the two.

Also Read: Different Types of Mutual Funds

Consideration Before Investing

What factors should you consider before investing in index funds? This question is not only for index funds but for each investment you decide to make. Well, investors must consider some important factors about index funds.

1. Asset Management Company & Its Reputation
2. Investor’s Investment Objective
3. Index Selection
4. Associated Risks
5. Past Performance
6. Tracking Error
7. Costs & Expense Ratios
8. Liquidity

Apart from this, you should start small & don’t panic about short-term volatility.

How To Invest In An Index Fund

Thanks to online investing platforms that made investing easy. Investing in an index fund is only a few steps away.

1. Register with any reputed online investment platform
2. Open an account & complete KYC
3. Research & select Index Fund
4. Choose the mode of investment i.e. lumpsum or SIP Investment
5. Make the payment
6. Review the performance periodically

Index ETFs

Index ETFs are another way to invest in index funds. They are designed to track specific indexes making them a convenient way to invest in index funds. You can purchase ETFs through a brokerage account just like buying individual stocks.

Taxes

Index Funds are subject to capital gains & dividend distribution taxes. They are taxed similarly to equity mutual funds if you invest in equity index funds.

A. Dividend Distribution Taxes (DDT): 10% is deducted at the source before the payment.

B. Short-Term Capital Gains: Gains from an investment with a holding period of less than one year are taxed at 15%.

C. Long-Term Capital Gains: Gains from an investment with a holding period of more than one year are taxed at 10% without the benefits of indexation. Plus, LTCG of up to 1 Lakh is not taxable.

Final Thoughts

This article is written for educational purposes and should not be considered as investment advice.

FAQs