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Aya Laraya had once said, “ When you invest, you are buying a day that you don’t have to work.” The world of investments is thus vast. It is important for you as an investor to know every fund before you make the right choice. Index funds in India are one of the most sought after mutual funds. We discuss them in the following analysis. Let’s begin!

What are index funds?

Many investors wish to diversify their portfolios. The same old quest to diversify! In this endeavor, they thus come across the world of index funds. Consequently, index funds are mutual funds which invest in bigger market index – like Nifty and Sensex. Also, all the stocks in these indices will also appear in the index fund portfolios of the investor. This will thus ensure that the portfolio performance will be identical to the index they are tracking.

One of the key benefits of index funds is they are passive funds. Passive funds are those funds that do not require minute-to-minute intervention by the portfolio manager, unlike active funds. Hence, the expense ratio is very low for index funds.

Index funds do not aim to outperform the market but to maintain a uniform path. Thus it helps the investor to manage or balance the associated risk in their portfolio.

How do index funds work?

One must understand that index funds generally track the indices they follow. For example, if an index fund is tracking Nifty, its portfolio will have 50 stocks in the same proportion as listed on Nifty 50. Moreover, an index is a group of securities that represent a segment of markets like bonds or stocks. The most popular indices in India are NSE Nifty and BSE Sensex.

Also, as index funds track one particular index, they are thus classified as passively managed funds. The fund manager subsequently chooses the stocks according to the composition of the underlying NSE or BSE benchmark.

An actively managed fund aims to beat the benchmark it is tracking while passively managed funds like index funds in contrast aims to match the performance of the index it is tracking. Index funds deliver the returns in line with the benchmark they track.

In spite of the expectations of the index fund matching its benchmark, there remains a scope of difference. This is also known as a tracking error. The fund manager should work towards reducing it as much as possible.

 

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Who should invest in index funds?

Investment in mutual funds depends upon your risk appetite and investment goals. Index funds are ideal for investors who prefer low risk and stable returns. Moreover, these funds do not require rigorous tracking. If an investor wishes to invest in equities but is not ready to take the risks associated with actively managed funds, they can choose a Nifty or Sensex index fund. Index funds will therefore give you returns that match the underlying index. However, if you seek market-beating returns, you can go for actively managed funds.

Factors to consider before investing in Index funds in India

1. Investment duration: Index funds are generally best suited for investors with a long investment outlook. These funds will undergo subsequent fluctuations in the short term which will average out in the long run. Consequently, it can be anything beyond 7 years which will generate returns in the range of 10% to 12%. Investors are thus advised to be patient for this period for the fund to achieve its true potential.

2. Risk appetite: As index funds track a particular index, they are generally less prone to equity-linked volatility and associated risks. Moreover, an investment in index funds will generate great returns in a rallying market. However, investors will have to shift to actively managed funds during a bear market. Index funds are known to lose their value during a declining market. It is advisable for investors to have a mix of actively managed funds and index funds in their portfolios.

3. Returns: Index funds track the performance of its underlying benchmark passively in contrast to an actively managed fund. They do not seek to beat the benchmark but imitate its performance. However, the returns generated may not be comparable to that of the tracked benchmark owing to tracking errors. Thus, it is advised to the investors to segregate those funds with low tracking errors.

4. Costs: The expense ratio on index funds is 0.5% and in most cases even less. Actively managed funds in contrast have an expense ratio of 1% to 2.5%. Since there is no need for actively managing index funds by the fund manager, the expense ratio is less.

5. Financial goals: Equity funds are thus ideal for achieving long term financial goals. Be it wealth creation or planning for your retirement, correspondingly these funds can help. Moreover, the risk to reward ratio is high which thus makes it a high return opportunity. In conclusion, it will help you in retiring early and pursuing your goals.

6. Taxation: The returns you will get from index funds will be thus treated as capital gains. It generally depends on the time you have been invested. If the holding period is up to 1 year, the STCG is 15% while if the holding period is more than 1 year, the LTCG is 10%.

advantages of Index fund in India

List of best index funds in India

On the whole, this is the most cost-effective and passive way to invest in the stock market. It has also been endorsed by Market gurus like Warren Buffet. Investment is advisable only if the holding period is beyond 5 years.

Index FundCurrent valueExpense ratio
Tata Index Sensex FundRs 8.47 lakh0.05%
Nippon India Index SensexRs 8.45 lakh0.1%
HDFC Index Sensex FundRs 8.45 lakh0.1%
IDFC Nifty FundRs 8.24 lakh0.15%

Index Funds vs Mutual Funds

Index Fund Mutual Fund
AimImitate the returns of the benchmark it is tracking, like BSE Sensex or NSE Nifty. Beat the returns of the benchmark index.
Invests inStocks, bonds, and various securities. Stocks, bonds, and various securities.
 

Managing

style

Passive. The portfolio is automated to match the holdings of the benchmark it is tracking. Active. Fund managers generally pick the stocks.
Expense

ratio

0.5% or less 1% to 2.5%
Average

5-year

returns

7.50% 15% – 17%
RiskLow High

 

Index Funds in India

Active investing vs Passive investing

Active investing, as the name suggests, requires active intervention by the fund manager. The objective of this investment is to beat the returns of the market and take advantage of the price fluctuations that happen. It requires an in-depth analysis and expertise so as to either buy or sell a particular asset. Generally, a fund manager is tasked with active portfolio management. The expense ratio for such funds is extremely high.

Passive investing in contrast is done for a longer time period. Investors limit their buying and selling which makes it a cost-effective method. The buy-and-hold mindset is required for this. This means that the investor will thus have to resist the temptation to react as per the market's next move. The expense ratio is much less since there is no oversight in stock picking. Moreover, the stocks in the portfolio simply match those present in the benchmark being tracked. There is greater transparency in passive investing as the fund manager cannot arbitrarily pick and discard stocks.

Conclusion

If you’re planning for wealth creation or worried about your retirement, think about Index funds. Index funds in India are one of the most promising avenues for investment. They have passively managed funds with an extremely low expense ratio. Subsequently, they seek to imitate the performance of the benchmark like BSE Sensex or NSE Nifty. They require a long-term outlook of 5 to 7 years for generating decent returns. So add value to investments by investing in these funds and secure your future self. Happy investing!

 

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