How do index funds work

Before diving into the subject, let us learn what the term index fund means. In simple terms, an index fund is a type of mutual fund whose portfolio matches the constituents of a market index, e.g., benchmark indices like Nifty or Sensex. An index fund is a diversified stock fund with the difference that the fund manager does not influence stock selection. The portfolio of an index fund mirrors an index at all times, both in terms of stock selection and percentage ownership. Because of this correlation, an index fund’s net asset value (NAV) moves virtually in line with the index it tracks. 

Let us understand this concept with an example. If the index (e.g., BSE Sensex) rises by 10% in a month, the NAV of an index fund linked to the Sensex will also increase by approximately 10% over the same period. Similarly, if the BSE Sensex goes down by 10%, the NAV of the index fund in question will also take a hit.

Index funds aim to expose investors to a broad range of stocks or securities included in a particular index and allow them to invest in the markets’ overall performance or a particular sector. 

Unlike actively managed funds that seek to outperform the market by buying and selling individual stocks, index funds are passively managed. It means funds are invested in the same securities as in the index and no changes are made to the portfolio composition. This  lowers management fees and operating costs because the fund manager does not have to conduct in-depth research and analysis on individual stocks.

Diversification is a key element of a good investment portfolio. Investors try to spread their funds across asset classes like stocks, bonds, real estate, gold, etc. Even within each asset class, they try to diversify further to minimise risk. In the case of stock investing, one popular way to mitigate risk is to diversify your stock portfolio by investing in stocks of companies from different sectors and with different market capitalisations. This is where index funds come in handy. Here we will look at index funds and discuss the different types of index funds in India, their benefits and much more.

How do index funds work?

Let us say an index fund tracks the NSE Nifty Index. This fund will have 50 stocks in similar proportions in its portfolio. An index can include stocks and equity-related instruments as well as bonds. The index fund ensures that it invests in all the securities that the index tracks.

While an actively managed mutual fund seeks to outperform its underlying benchmark, a passively managed index fund seeks to match the returns offered by the underlying index.

What are the factors that you should consider before putting your money in index funds?

• Risks and returns

Because index funds track a market index and are passively managed, they are less volatile than actively managed equity funds. Consequently, the risks are lower. During a market rally, index fund returns tend to give good returns. 

However, during a market downturn, switching to actively managed equity funds is usually recommended. Ideally, it would help if you have a healthy mix of index and actively managed funds in your portfolio. However, one component you need to be aware of is tracking error. So, before you invest in an index fund, you should look for a fund with the lowest tracking error.

• Expense Ratio

The expense ratio is a small percentage of the fund's total assets that the fund company charges for fund management. One of the biggest USPs of an index fund is its low expense ratio. Since the fund is passively managed, there is no need to develop an investment strategy or search and find stocks to invest in. This reduces the cost of fund management. 

Invest according to your investment plan

Index funds are recommended to investors with an investment horizon of 7 years or more. These funds are often subject to short-term fluctuations, but they tend to even out over a longer period of time. With an investment horizon of at least seven years, you can expect returns in the 10-12% range. So the key is to remain invested for as long as possible.

Taxes

As equity funds, index funds attract distribution tax and capital gains tax.

Distribution Tax (DDT)

When a fund house distributes dividends, a DDT or distribution tax of 10% is deducted at the source before the payment is made.

Capital gains tax

When you redeem shares in an index fund, you realise capital gains that are taxable. The tax rate depends on the holding period - the period you invested in the fund.

The capital gains you realise for a holding period of up to one year are short-term capital gains (STCG), which are taxed at 15%.

Capital gains earned by you on a holding period of more than one year is Long Term Capital Gain (LTCG). LTCG up to ₹1 Lakh is not taxable. However any gains made above this amount are taxed at a rate of 10% without indexation benefits.

There are different types of index funds in India. An investor can choose from the following:

Broad-based index funds:

A broad-based index fund in India tracks one of the broad based indices in India. For example, an index fund that tracks the NIFTY 500 is a broad-based index fund. Broad-based indexes are so-called because they give investors exposure to stocks of different market sizes and sectors. A broad-based index fund can provide investors with a high degree of diversification from a single investment.

Market capitalisation based index funds:

Market capitalisation-based indexes consist of stocks based on their market capitalisation.  Such indices include the Nifty Midcap 150, the Nifty Smallcap 250, etc. Index funds tracking such indices primarily invest in stocks of companies with large, medium or small market capitalisation based on the selected index. Index funds based on market capitalisation allow investors to passively invest in stocks with a certain market capitalisation.

Equilibrium index funds:

One way to counteract the underweighting or overweighting of an index weighted by market capitalisation is to choose an equally weighted index.

Smart beta or factor-based index funds:

Recently, factor-based index funds have gained prominence. Factor-based attributes such as revenue, cash flow, book value, dividend yield and price-to-earnings (P/E) ratio are metrics used to form a factor-based index. Index funds that track such indices are called smart-beta or factor-based index funds.

Following points will help you understand how Index funds work- 

1. Selecting an index: The first step is to select an index to track. This can be a broad market index, like the Nifty, or a sector-specific index, like the Nifty Auto.
2. Building a portfolio: Once the index is selected, the fund buys all or a representative selection of securities in the same proportion as the index. For example, if the Nifty index fund wants to replicate the performance of the Nifty50, it buys all 50 stocks in the index in the same proportion as the index.
3. Passive management: Index funds are passively managed, meaning they do not try to outperform the index they track. This approach is usually less expensive than actively managed funds, which require a team of analysts and managers to make investment decisions.
4. Diversification: Because index funds track an entire market index, they provide a high degree of diversification. This means that an investor can own a wide range of stocks with a single investment, reducing the risk associated with investing in individual stocks.
5. Low cost: Index funds typically have lower fees than actively managed funds because they require less active management. It means more of the investment returns are passed on to investors.
6. Rebalancing: Index funds periodically rebalance their portfolio to ensure that it continues to track the index accurately. This could include selling some securities and buying others to maintain the correct weighting.