All About Index Funds

Index funds have emerged as the most popular way to participate in the equity markets & now increasingly in other asset classes like debt, gold & even cryptocurrencies.

Did you know that Warren Buffett, the famed investor considers index funds as a good and safe way to save? He says that instead of picking specific stocks to invest in, it makes more sense for the average investor to buy an index fund that gives them access to all companies in the underlying index at a low price.

 What exactly is an Index fund??
An index fund is a mutual fund that tracks the performance of an underlying index, like the Nifty or the Sensex by holding the same stocks in the same proportion as in the index. Say, if Reliance Industries has a 10% weightage in Nifty 50, then a Nifty Index Mutual Fund’s portfolio will also give 10% weightage to Reliance Industries. Indian Index Funds are based on Gold, Nifty, Midcap, Gsecs, Bond index, etc.

How do Index Funds Work?

Indexing is a passive way to manage one’s investments. Instead of picking stocks to invest in and planning when to buy and sell them, a fund portfolio manager builds a portfolio whose holdings match those of an index. The idea is that if the fund mimics the profile of the index, its performance will be the same as that of the index.

Features of an Index Fund

Passive Investing

Investing in Index Funds is a passive form of investing. The opposite of passive investing is active investing, which is what actively managed mutual funds with a portfolio of securities and market timing do.

Active investing is when a mutual fund manager picks and chooses securities at his discretion based on the funds profile.

These funds have low volatility and thus lower risk than actively managed funds as they are based on an index. Index funds could get us promising returns when held for the long term, say between 7 to 10 years. A short-term slump won’t hurt your gains as your investment horizon is for the longer term and the market averages out. This is an effective diversification tool for your portfolio as it invests in all the best-performing companies and sectors in an Index.

Reduced costs

A lower management expense ratio is one of the main reasons why index funds are better than actively managed funds. The expenditure ratio of a mutual fund also called the management expense ratio, includes all of the fund’s operating costs, such as the pay of its advisers and managers, transaction fees, taxes, and accounting fees.

Since index fund managers just copy the performance of a benchmark index, they don’t need the help of research analysts and other people who help choose stocks. The fewer managers of index funds change their holdings, the less they have to pay in transaction fees and commissions. On the other hand, actively managed funds have bigger staffs and more transactions, which raises business costs.

The expense ratio shows how much more it costs to run a fund and passes those costs on to investors. So, inexpensive index funds usually cost less than 1 percent, usually between 0.2 percent and 0.5 percent, and some companies offer expense ratios of 0.05 percent or less. On the other hand, actively managed funds charge much higher fees, usually between 1 percent and 2.5 percent.

What is to be considered before investing?

Risk & Return

While Index funds may be perceived as carrying lower volatility than actively managed funds, it still is an investment in the underlying asset, be it equity debt or any other asset.

It is believed based on past performances that as compared to actively managed funds, index funds perform better during a bullish period and vice versa during a bearish or a slump period in the markets.

Tracking error

While an Index MF delivers similar returns as the main Index, the difference between an index’s performance and an Index fund’s performance is called the tracking error. Ideally, we need to choose a fund with the lowest tracking error record and more or less similar performance to its index. Hence, it is advised to shortlist funds with minimum tracking error before investing in an index fund. The lower the errors, the better the performance of the fund.

Tax

Equity Index funds attract the same capital gains tax as active mutual funds. ie, for a holding period of up to one year, Short-term capital gains (STCG) tax is applicable at a rate of 15%. Similarly, for a holding period of more than one year, Long-term capital gains (LTCG) tax, on gains above Rs 1 Lakh, is applicable at a rate of 10% without indexation benefit.

Who should invest in Index Funds?

Index MFs are well suited for those who have a low-risk appetite. It is also popular amongst new investors who have little knowledge about markets but are keen on investing and creating wealth for themselves in the long run. Also because they cost less than actively managed funds it is preferred by many investors.

Net net..

Diversification, low risk, low cost, and returns almost at par with a market index are some of the compelling reasons to invest in Index MFs.

Index Funds – A brief history

The first index fund was launched in 1976 by John C. Bogle, also known as Jack Bogle, the founder of Vanguard, an American Asset Management Company. The fund, initially called the First Index Investment tracked the S&P 500 Index and was later renamed the Vanguard 500 Index Fund. The Fund crossed the USD 1 billion mark in 1990 and as of Sept 2022, the total assets under management stood around USD 261.7 billion – one of the largest mutual fund schemes in the world.

India joined the passive investing bandwagon much later when UTI launched India’s first index fund in 1997, the UTI India Access, an offshore fund that tracked the NSE Nifty.

During the last 5 years, the passive investment landscape in India is showing encouraging trends. Passive funds AUM has increased from Rs 52,368 crores as on 31 March, 2017 to Rs. 4,99,319 crores as on 31 March, 2022 (annualized growth rate of ~57%) and in this period, the number of passive funds available in India has also grown from 84 as on 31 March, 2017 to 228 as on 31 March, 2022.

During the first quarter of FY 2024, there were nine schemes that were launched in the index funds category. In all 40 index funds were launched in the first half of calendar-year 2023; of these, there were 31 fixed-income index funds and nine equity-based index funds. In the last quarter ended March 2023, passive index funds garnered Rs 26,269 crore.

The sudden spike in flows in this segment could be attributed to the change in tax laws for the fixed-income mutual funds from FY 2023-24, which takes away the indexation benefit offered to investors until fiscal 2022-23. Investors therefore largely chose to invest in these funds to avail the benefit of indexation before the end of the financial year. With the change in the fiscal year from April onward, the amount of fixed-income index funds in the June quarter was muted.

Similar products

(1) Fund of Funds

A Fund of Funds (FoF) is a unique type of passive investment vehicle that invests in multiple mutual funds rather than directly in individual securities. By pooling funds from various sources, a FoF provides diversification across different asset classes, sectors, and markets. The fund manager selects and manages passive funds that align with the investor’s risk profile, which may come from the same or different fund houses. FoFs offer investors a convenient way to diversify their portfolios and reduce risk exposure.

(2) ETFs

Another product similar to a Mutual Fund is an ETF (Exchange-traded fund). Typically, ETFs will track a particular index, sector, commodity, or other assets, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can. ETFs can be traded at any time during the trading day, while index funds can only be traded at the end.

The trading value of an ETF is based on the net asset value of the underlying stocks that an ETF represents. ETFs typically have higher daily liquidity and lower fees than mutual fund schemes, making them an attractive alternative for individual investors.

Broadly, the difference between index funds and ETFs lies in the fact that index funds can be bought and sold like any other mutual fund.

But for ETFs, you will require a demat and a trading account, and you buy and sell them the way you buy and sell stocks.

Keep in mind though index fund is bought and sold at the NAV (or the Net Asset Value) whereas an ETF’s price can vary from the NAV. It typically trades close to the NAV but depending on demand/supply and liquidity the price may be different from the NAV.