1. How do Index Funds work?
When an index fund tracks a benchmark like the Nifty, its portfolio will have the 50 stocks that comprise Nifty, in the exact same proportions. An index is a group of securities defining a market segment. These securities can be bond market instruments or equity-oriented instruments like stocks. The popular indices in India are stock indices like BSE Sensex and NSE Nifty. Since index funds track a particular index, they fall under passive fund management. In this, the fund manager decides which stocks have to be bought and sold according to the composition of the underlying benchmark. Unlike actively-managed funds, there isn’t a standalone team of research analysts to identify opportunities and select stocks.

While an actively-managed fund strives to beat its benchmark, an index fund’s role is to match its performance to that of its index. Index funds typically deliver returns more or less equal to the benchmark. However, sometimes there can be a small difference between the fund performance and the index. It’s known as the tracking error. The fund manager will try to reduce the tracking error as much as possible.

 

2. Who should invest in Index Funds?
The investment decision in a mutual fund solely depends upon your risk preferences and investment goals. Index funds are ideal for investors who are risk-averse and want predictable returns. These funds do not require extensive tracking. For example, if you wish to participate in equities but don’t wish to take the risks associated with actively-managed equity funds, you can choose a Sensex or Nifty index fund. These funds will give you returns matching the upside that the particular index sees. However, if you wish to earn market-beating returns, then you can opt for actively-managed funds.

While the returns of index funds may match the returns of  actively-managed funds in the short run, however, over longer time periods, the latter tend to do better. 
 

3. Things to consider as an Investor
 

a. Risk
As discussed earlier, since index funds map an index, they are less prone to equity-related volatility and risks. Index funds are amazing options during a market rally to earn great returns. However, you need to switch to actively-managed funds during a slump. It’s because index funds may lose higher value during a market downturn. It’s always advisable to have a mix of actively-managed funds and index funds in your portfolio.

 

b. Return
Unlike actively-managed funds, Index funds track the performance of the underlying benchmark in a passive manner. These funds do not aim to beat the benchmark but to just replicate the performance of the index. However, many a times, the fund returns may not match that of the index on account of tracking error. There might be deviations from actual index returns. Before investing in an index fund, you need to shortlist a fund which has the minimum tracking error. The lower the number of errors, the better is going to be performance of the fund. 
 

c. Cost
Index funds usually have an expense ratio of 0.5% or even less. In comparison, actively-managed funds have an expense ratio of 1% to 2.5%. The reason being that the portfolio of the index funds is not passively managed and the fund manager need not formulate any investment strategy. The real differentiating factor between two index funds will be their expense ratio. If two index funds are tracking the Nifty, both of them will deliver largely similar returns. The only difference will be the expense ratio. The fund having a lower expense ratio will give marginally higher returns.
 

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d. Investment Horizon
Index funds are basically suitable for individuals who have a long-term investment horizon. Usually, the fund experiences a lot of fluctuations during the short-run which averages out in the long-run of say more than 7 years in order to give returns in the range of 10%-12%. Those who choose index funds need to be prepared to stick around at least for the said period to enable the fund to realise its full potential.
 

e. Financial Goals
Equity funds can be ideal for achieving long-term financial goals like wealth creation or retirement planning. Being a high risk-high return haven, these funds are  capable of generating enough wealth which may help you to retire early and pursue your passion in life.
 

f. Tax on Gains
When you redeem units of index funds, you earn capital gains. These capital gains are taxable in your hands. The rate of taxation depends on how long you stayed invested in index funds; such a period is called the holding period. Capital gains earned on the holding period of up to one year are called short-term capital gains (STCG). STCG are taxed at the rate of 15%. Conversely, capital gains made on holding period of more than 1 year are called long-term capital gains (LTCG).  Owing to recent changes in budget 2018, LTCG in excess of Rs 1 lakh will be taxed at 10% without the benefit of indexation.
 

4. How to Invest in Index Funds?
Investing in Index Funds is made paperless and hassle-free at ClearTax.

Using the following steps, you can start your investment journey:

Step 1: Sign in at cleartax.in
Step 2: Enter your personal details regarding the amount of investment and period of investment
Step 3: Get your e-KYC done in less than 5 minutes
Step 4: Invest in your favorite index fund from amongst the hand-picked mutual funds
 

5. Top 5 Index Funds in India
While selecting a fund, you need to analyze the fund from different angles. There are various quantitative and qualitative parameters which can be used to arrive at the best index funds as per your requirements. Additionally, you need to keep your financial goals, risk appetite and investment horizon in mind.

The following table represents the top 5 index funds in India based on the past 5 year returns. Investors may choose the funds based on a different investment horizon like 3 years or 10 years returns. You may include other criteria like financial ratios as well.

 

6. Features of an Index Funds

Most of the mutual fund schemes are actively managed to beat its benchmark. Such active management of fund does not always ensure the scheme outperforming its benchmark. As compared to actively managed scheme,  Index Funds are passively managed funds where the fund manager just imitates the parent index by investing in various companies in the same ratio as in the parent index.

As index fund is passively managed it does  not have to hire an expert people. The process of buying and selling can substantially be automated. It only involves the execution part of buy and  sell decision which does not cost much in terms of money.  The index fund just replicates the parent index, so does not have to trade more frequently ensuring minimum transaction costs as well. Such saving in overall costs help the index funds have significantly lower expense ratio as compared to actively managed funds. It helps the index funds boost their returns as compared to actively managed funds.

As per the Efficient Market Hypothesis (EMH) theory one can not beat the market consistently without raising the risk levels. The markets in developed nations are more transparent and the dissemination of information is quick and proper as compared to developing countries like India. This situation will improve in due course and the actively managed funds will no longer be able to beat the broader market index funds due to higher operating costs.  In addition to being cost efficient the Index funds are tax efficient as well if held for more than 12 months when it is treated as long term and are exempt upto Rs. 1 lakh and taxed @ 10% on balance profits. Any profit made within 12 months is taxed at flat 15%.

The exit load on actively managed fund is 1% if redeemed within one year but the exit load on index fund is may or may not be levied if you exit between 0 days to 30 days.  The lower lock in period in index funds gives you the opportunity to play  in the market without actually taking any direct exposure to specific security.

7. What is a tracking error and why it is there in the index fund  

The index fund has to deploy its funds in the stocks in the same ratio as in the parent index so logically it should give exactly the same returns before expenses ratio. However the return of index scheme deviate on both the sides due to the need to maintain some cash to meet redemption demand. This difference in return is called tracking error.  Lower the tracking error, better the fund’s performance. So the best index fund is one with zero tracking error. Even positive tracking error is not good as it reflects on calls taken by the fund manager on the market, which he is not expected to take.

8. Who should invest in Index Funds

Index funds as a product are ideal for investors who want to reap benefits of inherent potential of equities to give better returns in long run without having to churn their portfolio. The index funds are also ideal  for the people who do not want to take the risk associated with a fund manager. In case of an Index fund you need not worry about the fund manager as manager does not have any major role in performance of an index fund.

9. What type of index funds one should invest?

Since there are many index funds tracking various benchmark index, a lay person faces the problem of plenty. So for a lay investor who wishes to invest for long tenure goals like retirement or child education should invest in an index fund covering the broader market only and not in sectorial or thematic schemes as these are  restricted to specific segment, theme, industry etc  like mid cap or small cap or sectors like banks, consumer durables, health care, information technology, it is advisable to diversify the investment through broad based index fund.

A broader  index fund provides  broad market exposure with  low operating expenses.

 

While selecting an index fund in particular category, please select the index fund scheme with lowers tracking error, which reflects the efficiency of the operations of the fund.

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