Growing concerns about the ability of fund managers to generate optimal returns on investors’ mutual fund investments are prompting the latter to increasingly consider passively managed funds, including index funds. This article will cover everything you need to know about index funds before you consider investing in them.

An index fund is a type of mutual fund that purchases similar stocks as in a particular market index. This implies that the scheme will perform in tandem with the benchmark index it tracks.

An index is a group of securities that define a particular market segment. Since index funds track a specific index, they fall under passive fund management. Under passively fund management, the securities traded are dependent on the underlying benchmark. Additionally, passively managed funds do not require a dedicated team of research analysts to identify opportunities and pick the most-suited stock.

Contrary to an actively managed fund that strives increasingly to time and beat the market, an index fund is designed to match the performance of its index. Thus, index funds returns are aligned to their underlying market index.

The returns are more or less equal to the benchmark, except a small difference known as tracking error. The fund manager often tries to dial down this error as much as possible.

The following are the key differences between index funds and actively managed funds:

Following are some of the advantages enjoyed by index funds:

1. Low fees

Since an index fund mimics its underlying benchmark, there is no need for an efficient team of research analysts to help fund managers pick the right stocks. Also, there is no active trading of stocks. All these factors lead to low managing cost of an index fund.

2. No bias investing

Index funds follow an automated, regulation-based investment method. The fund manager is provided with a defined mandate of the amount to be invested in index funds of various securities. This eliminates human discretion/bias while taking investment decisions.

3. Broad market exposure

Investing money in a proportion similar to that of an index ensures that the portfolio is diversified across all sectors and stocks. Thus, an investor can seize the probable returns on the larger segment of the market through a single index fund. For instance, if you decide to invest in the Nifty index fund, you enjoy investment exposure to 50 stocks spread across 13 sectors, ranging from pharma to financial services.

4. Tax Benefits of Investing in Index Funds

Since index funds are passively managed, they usually enjoy low turnover, i.e. few trades placed by a fund manager in a given year. Fewer trades results in fewer capital gains distributions that are passed to the unitholders.

5. Easier to manage

Since fund managers do not have to worry themselves with how stocks on the index are performing in the market, index funds are easier to manage. A fund manager just needs to rebalance the portfolio periodically.

Index mutual funds tend to be ideal for risk-averse investors. Before making any investment decisions, it is prudent to make use of a mutual fund calculator to understand the potential returns of different funds. Such funds do not require extensive research and tracking. For instance, if you want to invest in equities but do not want to expose yourself to the risks associated with actively managed equity funds, you can opt for a Nifty or Sensex index fund.

You should consider the following features of index funds before you decide to invest in them:

1. Index Fund Returns

Index funds aim to replicate the performance of their market index. Unlike actively managed funds, they do not try to beat the benchmark. However, the returns generated may not always be at par with that of their underlying index owing to tracking errors. The lower the errors, the better the index fund will perform.

2. Risk tolerance

Since index funds map a particular market index, they are less prone to equity-linked risks and volatilities. It’s a good idea to invest in index funds to generate optimal returns amid a rallying market. However, things could get ugly during a market downturn as index funds tend to lose their value during a slump. Hence, it is always advised to have a mix of actively and passively managed index funds in your portfolio.

3. Cost of investment

The expense ratio of index funds is usually 0 less, as compared to actively managed funds This is because the fund manager is not required to formulate any investing strategy for index funds. However, it should be noted that even a fund with a lower expense ratio has the potential to generate higher returns on investment.

4. Taxation^#

You earn capital gains, which is taxable, upon redeeming the units of your index fund investment. The rate of taxation depends on your holding period, i.e. how long you stay invested. Short-term capital gains (STCG) or gains earned with a holding period of up to 1 year are taxed at 15% (plus surcharge as applicable plus 4% Health & education cess). Long term capital gains (LTCG) from funds held for more than 12 months attract long-term capital gains tax at 10% (plus surcharge as applicable plus 4% Health & education cess) if the total long term capital gains amount from equity oriented mutual funds/ equity shares exceed ₹1,00,000 in a year.

5. Investment horizon

Index funds can experience a lot of fluctuations in a short period. These fluctuations have the potential to average out the gains on your investment if they last long. Hence, index funds are ideal for those with a long-term investment horizon. If you choose to invest in index funds, you must be patient enough to allow the fund to perform at its maximum potential.

Example of Index Fund: Franklin India Index fund

Are you wondering how to invest in index funds? These days, investing in index funds has become effortless. You can even do it from the comfort of your home.

Here are the steps you can follow to begin your investment journey:

1. Online Process
   • Sign up for a mutual fund account on franklintempletonindia.com
   • Complete your KYC formalities (if you have not done it yet)
   • Enter the necessary details, as required
   • Identify the fund(s) you wish to invest in based on your financial goals
   • Select the fund and transfer the required amount
   • You can also create a standing instruction with your bank in case you want to invest via SIP (systematic investment plan) each month.

2. Offline/physical Process (In case you are you wanting to submit paper forms)
   • Duly fill the application form and KYC (know your customer) form (currently paused)
   • Enter the necessary details, as required
   • Identify the fund(s) you wish to invest in based on your financial goals
   • Make the payment of the investment amount via selected mode of payment.
   • Set up Billpay / eMandate / eNACH digitally or ADF (Auto Debit Form) or OTM (One Time Mandate) via offline in case you want to invest via SIP each month 

Index funds have the potential to save you a substantial amount of money and could lay a good foundation for your future. Owing to SEBI’s (Securities and Exchange Board of India) recent re-categorisation of mutual fund schemes, several financial planners strongly believe that index funds in India are likely to make their presence felt among the various investment avenues in the future.

# The information given here is neither a complete disclosure of every material fact of Income-tax Act 1961 nor does it constitute tax or legal advice. Investors are requested to review the prospectus carefully and obtain expert professional advice with regard to specific legal, tax and financial implications of the investment/participation in the scheme