What are index funds?

SEBI defines an index fund as one that invests a minimum of 95% of its total assets in the securities of a particular index that it is replicating/tracking. Index funds are open-ended schemes tracking a specific index.

An index fund invests in all the constituents of a benchmark index in the proportion of its index weightage. The returns of index funds mirror the performance of the index that it is tracking. The net asset value (NAV) of an index fund goes up or down, corresponding to the rise or fall in the level of the benchmark index. An index fund doesn’t try to beat the benchmark index.

Introduction of Indices in India

An index was introduced in India in 1986. Two of the most popular indices in India include the BSE Sensex and Nifty 50.

Comparison of BSE Sensex and Nifty 50

Feature	BSE Sensex	Nifty 50
Launch	The BSE Sensex was the first index to be launched in India on 2^nd January 1986.	The National Stock Exchange (NSE) launched the Nifty 50 index on 22^nd April 1996.
Representation	It is a basket of 30 stocks representing India’s large and liquid companies spread across diverse sectors.	A basket of 50 stocks representing some of India’s large and liquid companies spread across 13 sectors.
Base value	It was launched with a base value of 100.	It was launched with a base value of 1000.
Performance	As of June 2021, the Sensex trades above 52,000. It has compounded investor wealth more than 500 times in the last 35 years since its launch.	As of June 2021, the Nifty 50 trades above 15,000. It has compounded investor wealth more than 15 times in the last 25 years since its launch.
Major objectives	To measure market movements, serve as a benchmark for mutual fund schemes, serve as a benchmark for fund managers to compare the performance of their funds, serve as the underlying for index-based derivative products.	To serve as the benchmark for fund portfolios, serve as a benchmark for launching index funds, Exchange Traded Funds (ETFs), and other structured products.

BSE Sensex Vs Nifty 50

Nifty 50 Index returns over past 25 years

As we can see from the above chart, the Nifty 50 has multiplied investor wealth by more than 15 times (from 1,000 to above 15,000) since its launch. The Nifty 50 level of 15,200 is as of June 2021.

(Source: https://www1.nseindia.com/content/indices/ind_nifty50.pdf)

How do Index Funds Work?

If the market sector definition is to be considered, An index, is a collection of securities. Because they track a certain index, index funds are categorised as passive fund management. The securities traded in a passively managed fund are determined by the underlying benchmark. Furthermore, passively managed funds do not necessitate the use of a professional research team to identify chances and choose the best stock.

An index fund, unlike an actively managed fund that tries to pace and beat the market, is designed to mimic the performance of its index. As a result, the returns of index funds are associated to the underlying market index. Except for a slight variance known as tracking error, the returns are nearly identical to the benchmark. Frequently, the fund management will endeavour to minimise this inaccuracy to the greatest extent possible.

Types of indices available in India for launching index funds

There are various indices available in India that can be used by mutual fund houses to launch index funds in India. Some of the indices offered by the NSE include:

Broad Market Indices	Sectoral Indices	Thematic Indices	Fixed Income Indices	Strategy Indices
Nifty 50	Nifty Auto	Nifty CPSE	Nifty 10-year Benchmark G-Sec	Nifty 50 Futures
Nifty Next 50	Nifty Bank	Nifty Energy	Nifty Composite G-Sec	Nifty 50 Arbitrage
Nifty 100	Nifty Financial Services	Nifty Commodities	Nifty 4-8 year G-Sec	Nifty Alpha 50
Nifty 200	Nifty FMCG	Nifty India Consumption	Nifty 8-13 year G-Sec	Nifty High Beta 50
Nifty 500	Nifty IT	Nifty Infrastructure	Nifty 11-15 year G-Sec	Nifty Low Volatility 50
Nifty Midcap 50	Nifty Media	Nifty Services Sector	Nifty 15 years and above G-Sec	Nifty Dividend Opportunities 50
Nifty Midcap 100	Nifty Metal	Nifty 50 Shariah		Nifty Growth Sectors 15
Nifty Midcap 150	Nifty Pharma	Nifty PSE
Nifty MidSmallcap 400	Nifty Private Bank	Nifty MNC
Nifty Smallcap 50	Nifty PSU	Nifty Tata Group
Nifty Smallcap 100	Nifty Realty	Nifty Mahindra Group
Nifty Smallcap 250		Nifty Aditya Birla Group

This is not an exhaustive list of indices offered by the NSE. New indices are launched from time to time as per market requirements.

Mutual fund houses launch various index fund schemes with any of the above indices as the benchmark.

Who Should Put Their Money In Index Funds?

While index funds track a market index, their returns are very similar to the index’s. As a result, these funds are preferred by investors who seek consistent returns and want to invest in the stock market without taking too many risks. An actively managed fund’s portfolio composition is changed based on the fund manager’s assessment of the underlying securities’ expected performance. This increases the portfolio’s risk. Because index funds are handled passively, there are no such risks. The returns, however, will not be much higher than the index. For investors wanting higher returns, actively managed stock funds are a better choice.

Factors to Consider Before Investing in Index Funds in India

If someone wishes to invest in Index funds in India, the following factors to consider before investing would help:

Returns & Risks: Index funds are less volatile than actively managed equity funds since they track a market index and are managed passively. As a result, the hazards are reduced. Index fund returns are usually good during a market upswing. During a market downturn, though, it’s usually a good idea to convert to actively managed equities funds. In your stock portfolio, it is recommended that you should have a balanced mix of index funds and actively managed funds.
Expense Ratio: The expense ratio is a fee charged by the fund house for fund management services that is a small percentage of the fund’s total assets. The low expense ratio of an index fund is one of its most appealing features. There is no need to develop an investment plan or study and locate stocks to invest in because the fund is passively managed. Fund management costs are reduced as a result, and the expense ratio is reduced.
Invest in accordance with your investment strategy: Investors with nearly a 7-year or longer investing horizon may consider index funds. Short-term swings have been known to occur in these funds, although these fluctuations have been proven to average out over time. If you invest for at least seven years, you can expect returns of 10% to 12%. These assets can assist you in aligning your long-term investing goals and ensuring that you stay engaged for as long as feasible.
Consider Tax: Index funds are subject to dividend distribution tax and capital gains tax due to their status as equity funds.
Understand Capital Gains: When an index fund’s units are redeemed, capital gains are generated, which are taxed. The holding period, or the amount of time you were invested in the fund, determines the tax rate.

Index Funds vs Actively Managed Funds

There are some key differences between Index Funds and Actively Managed Funds, we have mapped the same below.

Index Funds

Goal: Index Funds attempt to replicate the performance of a market benchmark or index.

Risk Involved: The risks are directly aligned with its benchmark’s risks

Annual Expense Ratio: Index funds have a low expense ratio since they aren’t regularly reviewed.

Management Fees: Index funds have low management fees since they track their benchmark.

Actively Managed Funds

Goal: Actively managed funds strive to outperform their respective market benchmarks.

Risk Involved: When a fund underperforms its benchmark, such funds may be able to avoid taking on additional risks.

Annual Expense Ratio: The yearly expense ratio of actively managed funds is higher than that of index funds. Management Fees: Actively managed funds necessitate ongoing expert oversight, resulting in increased management fees.

Benefits of investing in Index Funds

Some of the benefits of investing in index funds include:

1. Low costs

Index funds are one of the most low-cost investment vehicles available. This is its biggest advantage[1] [2] . An index fund buys and holds securities as long as they are a part of the index. This does not allow regular churning of the portfolio which entails brokerage costs, taxes, and other transaction charges. The fund manager doesn’t need to spend time, money, and resources on research for stock selection. This results, in a lower expense ratio. Investors benefit from the lower expense ratio in the form of higher returns after expenses. The index fund expense ratio is in the range of 0.10-1.00% and that of an active fund is in the 1.00-2.00% range

(Source: www.bogleheads.org)

The above image compares investment returns from a low-cost index fund (expense ratio 0.2% p.a.) and a high-cost active fund (expense ratio 2.0% p.a). An individual makes a one-time investment of $10,000 in both funds. The funds grow at a CAGR of 8% over 30 years. The final amount accumulated in both the funds after 30 years is vastly different, due to a difference in expense ratios,

Due to the high expense ratio of 2% p.a., the final amount accumulated in the high-cost active fund is only $50,000. In contradiction, due to the low expense ratio of 0.2% p.a., the final amount accumulated in the low-cost index fund is $95,000. The difference in the expense ratio of 1.8% p.a. makes a big impact on the final amount accumulated in 30 years. As it can be seen from the graph, the final amount accumulated in the low-cost index fund is almost double of that in the high-cost active fund, even though both the funds have grown at a CAGR of 8%.

2. Diversification

Index funds offer diversification by investing in a basket of securities ranging from 30 to 500 stocks. Thus, if a few securities are not doing well in such a scenario, others will make up for their under-performance.

Apart from diversification based on the number of securities, index funds also offer diversification based on sectors. This is because the index constituents are from different sectors, except for sectoral index funds. Thus, if one sector is going through a bad phase in such a scenario, securities from other sectors will make up for their under-performance.

3. Elimination of fund manager discretion

The fund manager decides which stocks to buy in an active fund and how much to buy. This decision, although backed up by research, is subject to human discretion. There is no such scope for human discretion in index funds as the fund manager has no role to play in which stocks to buy and how much to buy. The purchase decision is based on the index constitution and the weightage to each constituent.

Disadvantages of Investing in Index Funds

While there are many advantages of investing in index funds, there can be some disadvantages. Some of the disadvantages include:

1. Tracking error

The tracking error represents the difference between the benchmark index returns and the index fund returns. The tracking error will be there due to cash levels maintained by the scheme, transaction costs, etc. The higher the tracking error, the lower the index fund returns compared to the benchmark index returns.

Ideally, when choosing index funds with the same benchmark index, you should consider the index fund with the lowest tracking error.

2. Concentration risk

Some indices can have concentration risk due to the high weightage of some constituents.

For example, as of 31^st May 2021, the top 5 constituents (Reliance Industries – 10.36%, HDFC Bank – 9.79%, Infosys – 7.66%, HDFC – 6.85%, and ICICI Bank – 6.80%) of the Nifty 50 Index had a total weightage of 41.46%. (Source: NseIndia.com)

Similarly, HDFC Bank alone has a weightage of 28% in the Nifty Bank Index. Such high weightage to few stocks can make the index movement lopsided in favour of the movement of these stocks.

3. No choice of index constituents

Some investors have a preference when it comes to choosing investment companies. For example, some investors prefer ESG (Environmental, Social, and Governance) compliant companies. Some prefer Shariah-compliant companies, and some prefer pharma companies that are not cruel to animals during clinical trials.

But, when you invest in an index fund, you cannot leave out the companies that belong to any of the above categories.

How to Invest in Index Funds?

Thinking about the whole idea of investing can be overwhelming. Nevertheless, there are simple steps to go about it. Investing in index funds has grown simple in recent years. It’s even possible to do it from the comfort of your own home. Here are the steps you may take to get started with your investment:

Invest Online:

Open a mutual fund account.
Complete the Know-Your-Customer (KYC) requirements (if you have not done it yet)
Now, get to fill in the blanks with the required information.
You will have to choose the mutual fund(s) you want to invest in based on your financial objectives.
Choose a fund and make the required transfer.
If you want to invest monthly via SIP (systematic investment plan), you can set up a standing instruction with your bank.

Invest Offline

Fill out the application and KYC (know your customer) forms completely (currently paused)
Fill in the blanks with the necessary details.
Based on your financial goals, choose the mutual fund(s) you want to invest in.
Make a payment for the investment amount using the payment method you’ve chosen.
If you want to invest via SIP each month, set up Billpay / eMandate / eNACH digitally or ADF (Auto Debit Form) or OTM (One Time Mandate) offline.

Returns on Index Funds

During a market rally, index funds typically provide strong returns. During a market downturn, however, switching to actively managed equities funds is usually a sensible option. In your stock portfolio, you should have a balanced mix of index funds and actively managed funds.

Penetration of passive funds in India

Index funds, along with Exchange Traded Funds (ETFs), are a part of passive investing. Passive investing as a theme started in the US in the 1970s. But, today, it has spread across the globe and has received a lot of acceptance in India also. As per the data reported by AMFI, the following are the statistics for May 2021.

Scheme name	No. of schemes	No. of folios	Net inflow for May 2021 (Rs. in crores)	Net AUM as of 31^st May 2021 (Rs. in crores)
Index Funds	47	11,81,906	1,204.61	22,904.76
Other ETFs	97	48,76,160	5379.76	2,99,664.67
Grand Total for MF Industry	1,597	10,04,36,145	-38,601.87	33,05,659.89

(Source: https://portal.amfiindia.com/spages/ammay2021repo.pdf)

As seen from the above table, passive investing makes up almost 10% of the overall mutual fund industry. In the future, passive investing is growing fast and is expected to garner a more significant share of the mutual fund industry.

The Bottom Line

Index funds have the potential to save you a lot of money and can help you build a solid financial future. Because of SEBI’s (Securities and Exchange Board of India) recent re-categorization of mutual fund schemes, numerous financial planners anticipate that index funds will become more prominent among India’s investment options in the future.

Invest in the best index funds with the Glide Invest App

Index funds should be a part of your overall investment portfolio along with active mutual funds. To select the best index funds and active funds based on your financial goals, risk profile, and asset allocation, you can partner with the Glide Invest App. You can start your financial planning journey and systematically invest towards your financial goals with the Glide Invest App. You will get guidance for:

A personalised risk profile assessment
Identifying your financial goals
Appropriate asset allocation
Making a financial plan for each goal
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Review and analysis of your financial plan
Hand holding you till your financial goals are achieved.

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FAQs

Q1: Is it true that index funds are preferable to stocks?

A1: Index fund investing outperforms individual stock investing in general because it keeps costs low, eliminates the need to continually monitor corporate earnings reports, and almost always results in “average,” which is considerably preferable than losing your hard-earned money in a lousy investment.

Q2: What are the advantages of buying index funds?

A2: Investing in index funds has a number of advantages.

Fees are low. An index fund does not require a huge team of research professionals to assist fund managers in selecting the best companies because it matches its underlying benchmark.
There are no biases when it comes to investing….
Exposure to a large number of markets…
Investing in index funds has tax advantages.
It’s a lot easier to manage.

Q3: Should I be investing in India’s index funds?

A3: For risk-averse investors seeking consistent returns, index funds are appropriate. This money does not demand a lot of thought. If you want to invest in equities but don’t want to take on the risks associated with actively managed equity funds, you can choose a Sensex or Nifty index fund, for example.

Q4: Are index funds a high-risk investment?

A4: Investors will not make the enormous returns that they might from high-risk individual equities because index funds are low-risk.

Q5: Is it true that index funds pay dividends?

A5: Index funds will distribute dividends based on the securities they own. Investors will get monthly dividends from bond index funds, which will pass on bond income. Stock index funds pay dividends quarterly or once a year