What are Index Funds?
Index fund is a specialized type of mutual fund which replicates certain indices like Nifty (NSE 50 Index) and Sensex (BSE Sensitive Index). The portfolio of an Index fund is built up by tracking standard market indices. Index funds follow indices’ performance passively, unlike actively managed funds. So, they also go by the name of passive mutual funds.
Types of Index Funds
There are a number of index funds. Here are the types:
- Broad Market: A big market would naturally want to capture a wide range of the market. Large market index funds usually have the smallest expenditure ratios. The asset sales in broad index funds are generally small and tax-efficient as well. This is suited for those investors who wish to achieve a huge variety of shares or bonds.
- International Index Funds: The Global Index funds present you with international exposure. An investor could opt for funds that monitor indexes that are no longer linked to any particular geographic region in the emerging or frontier markets.
- Market Capitalization: The investors who are involved in the long term investment horizon would benefit from an increased exposure towards a wide range of small and medium-sized enterprises. Index funds could help you in achieving this goal via market capitalization.
- Bond Based Index Funds: Bond Based Index funds could help you in maintaining a balanced combination of short, intermediate and long term bond maturities which result in steady revenues.
- Earnings Based: Index funds also have the capability of working on the basis of the profits or revenues gained by a company. You can find two types of indices linked to companies which are growth indices and value indices. The growth indices are generated with businesses with the expectation of generating profits faster than others in the market. The value indexes consist of stocks that are trading at a lesser cost as compared to the company’s earnings.
How do index funds work?
Index funds monitor a specific index and are passively managed funds. The fund manager decides which stocks should be chosen for purchase and sold according to the underlying index followed by the fund. A separate analysis is taken for the identification and selection of stocks for investments.
Index funds monitor benchmarks such as Nifty, its portfolio would have the same proportions of the 1000 stocks which Nifty consists of. Suppose, two Index funds are tracking the same index, then they are bound to offer the same returns. If a fund has a lower expense ratio, it will give rise to comparatively greater revenues on investment.
The work of an active fund is to meet the benchmark allotted to it. But the purpose of an Index fund is to be as efficient as its index performance. These typically yield returns that are almost equivalent to the benchmark. The index could slightly differ from the results of the fund. This is known as tracking error. The work of a fund manager is to make sure that the tracking error is the lowest possible figure.
These are perfect for those who want to invest in equities but do not want to track the performances. Index funds are also pretty good for investors with a long term investment horizon. It is important to keep in mind that the Index fund returns might match those of an actively managed fund, in the short term. In the long term, however, the actively managed fund goes on to perform much better.
How to invest in index funds?
If you want to invest in a mutual fund, you could do that in two ways, either directly or via an agent. In case of a direct approach, you could proceed either online or offline by visiting the mutual fund branch office. You would need a financial adviser in that case but you won’t have to pay any sort of commission to the distributors and hence, the returns would be maximized. While going through an agent, make sure that they are registered with the Association of Mutual Funds in India and do have an AMFI Registration Number.
Before you proceed to make an investment, you must look into the track record of the Index fund and product labeling as well. According to the SEBI regulations, all mutual funds need to specify their schemes as per the following parameters:
- Nature of the scheme
- Gist about the objective of the investment
- Level of risk
Who Should Invest in Index Funds?
Index funds come across as ideal for investors who prefer to invest for long terms. A look into the historical performance of the market indices would give you the knowledge of their performance in the long run despite having plenty of incidences of short term volatility.
These are suited for those investors who wish to gain long term wealth but prefer staying away from constant monitoring of their mutual fund portfolio.
Benefits of index funds and Why should you invest in Index Funds?
- Low Expense: Index funds are managed passively, so the total expense ratio, i.e. the TER is very low when compared to those that are actively managed. An actively managed fund could charge you anything around 1-2% as TER. On the other hand, an Index fund would just charge you in the range of 0.2% to 0.5%. The cost difference could seem very small at the face value but in the long run, it could turn out to be a huge sum of money.
- No Fund Manager’s risk: The allocation of assets, in this case, is not according to the will of the fund manager. So, there is no visible scope of making losses due to improper asset allocation or perhaps, poor management.
- Diversity: When it comes to market capitalization, Index fund is amongst the top. This can be translated as the leading market players across various sectors would participate in the benchmark index. Due to the auto diversification, there is reduced risk from staying invested in a particular sector.
- Effective Market Hypothesis: An Index fund which is a representative of the market shall outperform all active funds in the long run. This is due to the fact that major economic thinkers have contributed to the efficient market hypothesis which cannot be outperformed by any fund manager or investor. Competitors get to know about the price anomalies at a certain point of time and the stocks are kept at a price according to their fundamental value.
How to Choose the Best Index Funds to invest?
If you want to choose the best Index fund, then you must take into consideration the following factors:
- Risk Tolerance: Index funds are not prone or less prone to the volatility related to equity and risks because they map an index. If you are looking for high returns, then investing in Index funds could be an excellent choice. You will have to switch to actively managed funds if you encounter a market slump. Index funds lose their value when there is a market downturn. It is advised to invest in a mix of actively managed index funds.
- Return Factor: Index funds passively track the performance of the underlying benchmark. They do not proceed with the goal of beating the benchmark. These funds just have the motive of replicate the performance of the index. The returns generated might not meet the index due to tracking errors. An investor should shortlist funds which have minimum tracking error before making an investment in an index fund.
- Cost of Investment:The index funds usually go with an expense ratio of 0.5% or maybe even less. Compared to that, actively managed funds have an expense ratio in the range of 1% to 2.5%. The difference is due to the fact that the fund manager does not need to formulate any investment strategy. You should choose the index fund with a lower expense ratio to receive higher returns.
- Investment Horizon:The index funds generally are suited for investors who have a long term horizon for investment. The fund usually goes through plenty of fluctuations on the short run. This averages out in the long run. So, if you want to allow the Index fund to perform to its full potential then you should opt for long term investments.
- Financial goals: If you wish to achieve long term financial goals, for example child’s higher studies or your retirement goals, then Index funds are an ideal choice for you.
- Tax Benefits:Every time you redeem your units of Index fund, you earn some capital gains. Now, the rate of taxation would depend on how long you invested in index funds, the holding period. When the holding period is of one year, the capital gain is known as STCG (Short Term Capital Gains) and its tax rate is 15%. However, when the holding period is for more than a year, such capital gains are called LTCG (Long Term Capital Gain). This has a tax rate of 10%.
Best Index Funds in India for 2020:
Here is the list of Best Index Funds in India for 2020
|ICICI Prudential NV20 ETF|
|Motilal Oswal NASDAQ 100 ETF|
|SBI ETF Nifty Next 50|
|UTI Sensex ETF|
|HDFC Sensex ETF|
|IDBI Nifty Fund Direct Plan|
What are the Disadvantages of Investing in Index Funds?
- Difficult to generate alpha: It is tough for a fund manager to outperform the stock market every time but many investors and actively managed funds are actually able to outperform the market. The Index funds don’t have that potential since they have the tendency to track the market performance not of exceeding it.
- Restricted protection: Suppose you have invested in an Index fund which tracks Nifty50, it will soar when the market is doing well but will leave you vulnerable when the market is not doing so well. During a market correction, it would be difficult to turn your costs into an average value since the weightages of the underlying index have to be looked after.
- Can’t avail sudden opportunities: Oftentimes, an obvious mispricing occurs in the market. This could be a good opportunity to add up on good quality yet beaten down socks in the sector. However, an Index fund would be unable to make use of this opportunity to the fullest and will gain you suboptimal returns.
- Only mature companies:The index companies are mostly the mature companies who have their best growing years in the past. Investors in index funds hence, cannot benefit from the high growth potential of the emerging small companies.
Index Funds vs. Mutual Funds
- Investments: Index funds, as well as the mutual funds, consist of stocks, bonds and other types of securities. However, index funds focus on tracking stock consisting of different indexes like Nifty, Nasdaq, etc.
- Management: One major difference is the management. Index funds are passive, that is, they do not actively trade or add investments. While mutual funds are active which means that the fund managers actively pick up fund holdings after analyzing them.
- Objectives: The main objective of the index fund is to generate the same returns as the benchmark index. While mutual funds aim to beat the returns of the benchmark index. If the market is volatile, then it would be harder to pull out your index funds on short notice.
- Cost: Mutual funds will cost you more in terms of expense ratio (fees around 1%-3%). Index funds, on the other hand, have lower costs with annual fees in the range of 0.05% to 0.07%.
Difference between Index Fund and ETF
An Exchange Traded Fund or an ETF tracks an index, like an index fund. But the ETF units are listed as well as traded on the stock market and cannot be bought easily from an Asset Management Company (AMC) or even sold to a fund house. You need a Demat and a trading account to buy a unit of ETF and you need to buy them in the stock exchange.
The index fund, on the other hand, could be opted for by any other mutual fund directly or even redeemed. Index funds, sometimes, only hold units of an ETF of the same AMC and in the rest of the times, Index funds directly hold the stocks included in the index. There are some indices that are not traced by Index Funds but are tracked by ETFs. Indexes like Nifty Value 20, Nifty Low Vol 30 are tracked by ETFs which are not tracked by Index funds.
Do any index funds provide guaranteed returns?
There are basically, no guaranteed returns when it comes to index funds investments. All Index funds do is track the performance of a specific index like Nifty, Sensex, etc. It is subject to market volatility, always and therefore, you need to read the offer document carefully to understand the risks it is subject to.