What are Index Funds?

Published on July 31, 2025 | 5 min read

Summary

Index funds are passive investments that track market indices such as the BSE Sensex and Nifty 50. These indices consist of fundamentally strong, large-capitalisation companies and are regularly rebalanced to reflect changes in market capitalisation.

Key Takeaways

Index funds are a type of mutual fund that invests in indices or benchmarks, requiring low maintenance and management.
Index funds are suitable for beginners and long-term investors with low risk tolerance seeking passive investments to build wealth.
Since these funds follow the market, the value of index funds declines during market downturns.
The expense ratio of these funds is comparatively lower than that of an actively managed fund, as these require less supervision and active management.

Introduction

Investing can be overwhelming, and equity investments are often complex and highly risky. If you seek equity-like returns with minimum risk, you may consider Index funds. Index funds invest in specific indices such as the BSE Sensex and the Nifty 50, which comprise of top fundamentally strong companies with large market capitalisation.

Open FREE Demat Account within minutes!

Join now

Let’s understand Index funds in detail and whether they are the right investment option for you.

What Are Index Funds & How Do They Work

Index funds are a type of passive mutual fund that tracks specific indices such as the Nifty 50 and the Sensex. These funds are SEBI-regulated and invest in all companies included in the target index, adjusting their holdings to reflect changes in the underlying index.

Index funds require minimal involvement from fund managers, as they do not need to research and select individual stocks. This reduces the fund’s expense ratio, thereby increasing your net profit. With index funds, investors know exactly which stocks their money is invested in, providing complete transparency.

As index funds track indices, the value and returns on your investments depend on market conditions and performance.

For example, the Ministry of Finance reported that the Nifty 50 and Sensex gained approximately 11.1% and 10.1%, respectively, during April-December 2025. This indicates that investors in index funds tracking these benchmarks achieved similar returns.

Who Should Invest in Index Funds?

Index funds are suitable for beginners seeking a simple and easy-to-understand investment option, as well as for investors aiming to build long-term wealth with low costs and minimal maintenance.

Factors to Consider When Investing in Index Funds

Index funds are low-cost and diversified investments that reflect the broader market performance. Before investing in index funds, consider the following factors.

Investment Duration

Index funds are suitable for long-term investors since these funds require time to generate considerable returns.

Expense ratio

The expense ratio is the fee an AMC charges for managing your investments. Index funds usually have a lower expense ratio, so compare the Total Expense Ratio (TER) of different funds and opt for one with a lower TER.

Tracking Error

Tracking error refers to the standard deviation of the difference between a portfolio’s returns and its benchmark’s returns. It is advisable to select an index fund with lower tracking error.

Fund Size & Liquidity

Before investing in any index fund, check the AMC’s Asset Under Management (AUM) to ensure better liquidity and efficiency in transactions.

Market Conditions

Since an index fund mirrors the market; it is important to understand market cycles to plan your strategy and make informed decisions.

Taxation

Equity index funds held for more than 12 months are eligible for tax exemptions and are subject to a lower tax rate. The following are the types of index funds and the taxes applicable based on the holding period.

Type of Index Fund	What It Invests In	LTCG Tax Rate	STCG Tax Rate	Exemption
Equity index fund	Indian stocks	12.5%	20% flat	₹1.25 lakh
Sectoral/thematic index fund	Indian stocks (sector-specific)	12.5%	20% flat	₹1.25 lakh
Debt index fund	Indian bonds / G-Secs	Taxed as per your income slab	Taxed as per your income slab	NIL
International index fund	Global stocks	12.5% (Holding period 2 years)	Taxed as per your income slab	NIL

Pros & Cons of Index Funds vs ETF

Let’s compare different features of index funds and ETFs so you can choose the right investment option for you.

Feature	Index Fund	ETF
Return (5 Year)	10.12%–24%	25–40%
Risk	Lower Risk	Slightly riskier due to trading
Expense Ratio	Higher than ETFs	Lower

If you want to invest in equity but lack the skill or time to manage your investments, you can opt for index funds. Index funds are passive investments that require little supervision and hence charge a lower expense ratio. Based on the type of fund, you can avail tax deductions of up to ₹1.25 lakh in a single financial year, making them a tax-efficient investment.

FAQs

What Are Index Funds?

Index funds are a type of mutual fund that invests in a specific market index, such as the Nifty 50 or Sensex. These are passive investments as they require little participation from professional fund managers and hence carry a lower expense ratio compared to actively managed funds.

Who Should Invest in Index Funds?

Beginners and risk-averse investors seeking equity returns and wanting to build wealth in the long run can invest in index funds.

Do Index Funds Offer Tax Benefits?

Index funds are taxed based on their type. While equity index funds are eligible for an exemption of up to ₹1.25 lakh in a financial year.

Are Index Funds Safe To Invest In?

Index funds are strictly regulated by SEBI and are less volatile than actively managed equity funds, making them a low-risk investment.

About Author

Mariyam Sara

Sub-Editor

holds an MBA in Finance and is a true Finance Fanatic. She writes extensively on all things finance whether it’s stock trading, personal finance, or insurance, chances are she’s covered it. When she’s not writing, she’s busy pursuing NISM certifications, experimenting with new baking recipes.