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Index funds are a particular type of mutual funds that are gaining popularity among Indian investors. Low costs but high performance equivalent to actively managed funds make index funds a top choice for investors. Here, in this guide, we help you understand the basics and benefits of index funds so that you can decide whether it is the right choice for you.
What is an index fund?
As the name implies, it is a type of mutual fund whose portfolio reflects the composition of a market index like the Sensex or the Nifty 50. The fund invests in stocks that constitute the benchmark index. For instance, a Nifty-50 index fund will only invest in stocks that make up the Nifty-50 index.
Another salient feature of an index fund is that the assets are allocated in the amounts proportional to the stock composition of the index. For example, let’s state that RIL (Reliance Industries Limited) holds 10% weightage in the Nifty-50 index, then a Nifty-50 index fund also allocates 10% of its assets to RIL.
The basic working of an index fund is that it replicates the performance of a market index, to generate similar returns at a minimal cost. Compared with other mutual funds like equity or debt-oriented funds, index funds do not require active management. Hence, they are known as passive funds.
As a result, the expense ratio of index funds is further reduced, thereby making them cost-efficient to investors.
Benefits of Investing in Index Funds
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Low Expense Costs
As mentioned above, index funds are passively managed, thereby reducing the TER (Total Expense Ratio). The TER of an index fund generally ranges around 0.20% to 0.50%. Compare this with the TER of an actively managed fund, which lies anywhere from 1% to 2%. While the difference may seem small, in the long run, higher expense ratios could lead to a significant loss in your net returns.
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Benefits of Diversification
One of the biggest benefits of index funds is that it helps in the diversification of your portfolio. Generally, an index fund invests in the top companies across sectors. All leading companies in terms of market capitalization, are part of the benchmark index, be it Sensex or Nifty-50. When you invest in an index fund, you automatically include stocks of these companies in your portfolio, thereby increasing diversification. The auto diversification reduces the risk compared to investing in a particular sector or commodity.
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No Scope for Human Error
In other mutual funds, the fund manager decides the stocks to invest in. The fund performance fund ultimately rests on the decisions made by the fund manager and his/her team.
However, in an index fund, the allocation of assets is not at the discretion of the fund manager. Hence, there is no scope for losses due to errors made by the fund manager.
The Disadvantages of Index Funds
Now that we have seen the benefits of index funds, let’s take a look at the flipside – the cons of investing in index funds.
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Scope for Underperformance
In an actively managed mutual fund, a smart fund manager makes the right switches, thereby enhancing the chances of beating the market and boosting returns. On the other hand, in an index fund, the performance of the fund is tied to market performance.
The efficient market hypothesis works well in developed countries that have steady market indices. On the contrary, in developing nations like India, the volatilities of the market impact the returns from index funds.
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Missing out on Higher Growth Potential
Index funds invest only in mature companies that are leaders in market capitalization. While these companies generate steady returns, they do not show high growth. As a result, investors of index funds miss out on the considerable growth benefit of mid and small-cap companies.
Additional Reading : Best Performing Mutual Funds
Two Major Types of Index Mutual Funds
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Sensex Index Funds
These funds track the BSE Sensex benchmark and invest in the 30 companies listed on the BSE Senses.
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Nifty Index Funds
These funds track the Nifty 50 benchmark and invest in the 50 companies listed on the NSE.
The weightage of funds allocated is similar to the weightage of allocation in the benchmark index.
Who is it for?
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Investors with a long-term investment horizon
Ideally, index funds are best suited for investors who are looking to build their wealth over the long term. A look at the historical performance of the Nifty-50 and Sensex market indices shows that these markets have performed well in the long run, despite facing several short-term fluctuations.
To give an example, the base price of the Sensex market index in 1979 was Rs. 100. Today, the base price has increased over 400 times, and the current valuations are at Rs. 40,000 on average. As you can see, index funds have the potential to offer high returns for investors who are looking to build their wealth in the long run.
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Investors who want a hands-off investment approach
Unlike other mutual funds, in an index fund, there is no need to monitor and juggle your portfolio continuously. If you are looking for an investment that requires a hands-off approach, then index funds are the right choice for you.
Index Funds: FAQs
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Are index funds and ETFs the same?
No. An ETF (Exchange-Traded Fund) is similar to an index fund, as both track a market index. However, the similarities end there.
The units of an ETF are listed on the stock market and cannot usually be purchased from an Asset Management Company. To buy units of an ETF, the investor has to hold and operate demat and trading accounts. The units of the ETF are purchased directly on the stock market.
On the other hand, an index fund is just like a regular mutual fund. The units of an index fund can be purchased directly from an AMC.
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Which market indices do index funds track?
In India, the majority of index funds either track the Nifty-50 or Sensex. Besides these two, other benchmarking indices tracked by index funds are:
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Nifty Next 50 – It is an index of the next 50 most significant stocks that didn't make it to the Nifty-50 index.
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Nifty Value 20 – It is an index that tracks undervalued stocks based on parameters like Dividend Yield, Price to Book Ratio, Price to Earnings Ratio, and Return on Capital Employed.
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Nifty Low Vol 30 – This index tracks 30 major stocks that have low volatility.
Additional Reading : Valuation Of Mutual Funds
Top 10 Best-Performing Index Funds in India
With so many index funds in the market, finding the best ones to invest in is a Herculean task. To simplify the fund selection procedure, we have compiled a list of the top-performing index funds in India. Compare the returns and expense ratios and pick a winning fund to invest in.
| S.No. | Fund Name | 1-Year Return | 3-Year Returns | 5-Year Returns |
| 1 | Aditya Birla Sun Life Index Fund – Direct-Growth | 15.12% | 14.48% | 7.63% |
| 2 | LIC MF Index Fund Sensex | 17.27% | 16.08% | 7.86% |
| 3 | Franklin India Index Fund – NSE Nifty Plan – Direct-Growth | 15.11% | 14.53% | 7.91% |
| 4 | Nippon India Index Fund – Direct-Growth – Nifty Plan | 15.72% | 15.20% | 8.13% |
| 5 | Tata Index Fund – Direct Plan – SENSEX | 17.74% | 16.79% | 8.52% |
| 6 | ICICI Prudential Nifty Next 50 Index Fund – Direct-Growth | 5.07% | 10.20% | 9.87% |
| 7 | HDFC Gold Exchange Traded Fund Regular Growth | 30.27% | 5.54% | 5.85% |
| 8 | SBI – ETF Gold Regular Growth | 30.44% | 5.13% | 5.69% |
| 9 | Nippon India ETF Long Term Gilt Regular Growth | 16.70% | 7.77% | – |
| 10 | IDBI Gold Exchange Traded Fund Regular Growth | 30.46% | 5.69% | 6.07% |
*Note that returns from these funds are subject to change based on market fluctuations. Make sure to choose funds based on your investment goals.
#Data as on December 2019, from Value Research
EndNote
Should you invest in index funds?
With index funds growing in popularity, more and more asset management companies are offering index funds. As an investor, allocating a portion of your funds in index funds can help you generate higher returns at low expense costs.
However, note that index funds offer higher returns in the long-term rather than for short-term investments. So, if you have a long investment horizon and wish to diversify your portfolio to include passively managed funds, then index funds are an excellent investment option.