What are index funds? Know the benefits and how they work

Investing in the stock market can often seem daunting, especially for beginners. However, a popular and effective way to participate in equity markets with reduced risk is through equity mutual funds. There are different categories of equity mutual funds, and index funds are one such category of funds that mirror a particular stock market index.

Let’s explore index funds, how they work, and their advantages while providing insights for potential investors on key factors to consider before making investment choices.

Understanding index funds

At their core, index funds are a type of mutual fund to track the performance of a specific stock market index, such as the NSE NIFTY or BSE SENSEX. Rather than being actively managed by a fund manager who picks individual stocks, index funds passively mirror the composition of their chosen index. This means they invest in the same stocks as the index in the same proportions, providing investors with an easy way to gain exposure to the most valued stocks listed both on the BSE and NSE.

How index funds work

To illustrate how index funds work, let us take an example of an index fund that tracks the NSE NIFTY Index, which comprises 50 prominent stocks. This fund will hold those 50 stocks in its portfolio, maintaining the same weightings as in the index. Broader indices, like the NIFTY Total Market Index, may include hundreds of stocks from various sectors and market capitalisations.

An index fund's primary objective is to match, rather than outperform, the returns of the index it tracks. This passive investment strategy leads to lower management costs and often results in more consistent performance relative to actively managed funds.

Who should consider investing in index funds?

Index funds can be an excellent choice for investors who prefer a hands-off approach to investing in equities. They are particularly appealing to those who seek predictable returns and wish to mitigate risks. Because index funds are less volatile than actively managed equity funds, they can be a suitable option for conservative investors or those new to investing in equity instruments.

However, it is essential to note that while index funds can provide solid returns that closely align with the performance of the underlying index, they may not yield the higher returns that actively managed funds could potentially offer. For investors with a higher risk appetite seeking substantial growth, actively managed equity funds could be a more suitable alternative.

Consider these factors before investing

Before putting money in index funds, potential investors should consider several important factors:

• Risks and returns: While index funds generally exhibit lower volatility than actively managed funds, they are not entirely devoid of risks. The returns on index funds typically correlate with market movements, meaning they can benefit during bullish trends but may also reflect downturns during bearish phases. It is advisable to maintain a balanced portfolio that includes both index funds and actively managed funds to diversify risk effectively. One crucial aspect to be mindful of is the tracking error, which measures how closely the fund's performance matches the index's. Opting for funds with a low tracking error can enhance your investment experience.
• Expense ratio: The expense ratio refers to the annual fees charged by the fund house as a percentage of the total assets. A key advantage of index funds is their generally low expense ratios compared to actively managed funds. Index funds require less intensive management and research. Operational costs are lower for such funds, making them an attractive option for cost-conscious investors.
• Aligning with your investment plan: Index funds are best suited for those with a long-term investment horizon, ideally seven years or more. Although they may experience short-term fluctuations, their performance tends to stabilise and improve over time. With a commitment of at least seven years, investors can reasonably expect returns averaging between 10% and 12%. Therefore, aligning your investment strategy with long-term goals can yield fruitful outcomes.

Tax implications

Index funds, like other equity investments, are subject to taxation. Investors should be aware of the relevant tax implications, including:

• Short-Term Capital Gains (STCG): If units are sold within one year, the gains are taxed at a rate of 15%.
• Long-Term Capital Gains (LTCG): Gains on investments held for more than one year are taxed differently. LTCG up to ₹1 lakh is tax-exempt, while gains exceeding this threshold are taxed at 10% without the benefit of indexation.

Types of index funds

In India, index funds can be categorised based on the underlying index they track. Here are a few common types:

• Equity Index Funds: These funds primarily invest in stocks and aim to replicate the performance of equity indices like the NIFTY 50 or BSE SENSEX. They are popular among investors looking for capital appreciation over the long term.
• Sectoral Index Funds: Sectoral index funds focus on specific sectors of the economy, such as banking, technology or healthcare. While they can provide higher returns during sector booms, they also carry greater risk due to their concentrated nature.
• International Index Funds: These funds invest in global indices and provide Indian investors with exposure to international markets. These funds help diversify a portfolio by adding international equities, reducing reliance on the Indian market.

To sum up, as the mutual funds investment landscape evolves, index funds are becoming increasingly popular in India. With growing awareness and acceptance of passive investing strategies, more investors are considering index funds as a viable option for building wealth.