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Index Fund : Starter Guide

Index fund

As the name suggests, Index fund are the type of mutual funds or ETFs which invest in securities constituting a financial market index in a similar proportion. As per SEBI, at least 95% of the total assets should be invested in securities of a particular index being replicated.

Table of Content

What Are Index Fund?

Also known as passively managed funds, Index funds are type of mutual fund which imitate the portfolio of an Index. These funds provide broad market exposure, lower expenses and low portfolio turnover when compared to actively managed funds.

index fund faq
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Index funds are still not very popular in India due to the fact that India market is still not fully developed and active fund managers are still able to beat their benchmark and generate extra returns, However the situation is changing and its getting difficult for active funds to beat their benchmark increasing.

Legendary Investor Warren Buffet has said, common investor would be much better in buying low cost index funds instead of picking individual stocks when it comes to long term wealth building.

As per the latest report publish by SPIVA, more than 67% percentage of large mutual funds couldn’t beat the benchmark Nifty-50 ,over 10-year period ending in June-2020.

How Do Index Fund Works?

Lets say an Index fund follows NSE NIFTY-50 index. As we already know that there are 50 stocks in the NIFTY-50 index , this Index will also invest in same 50 stocks in similar proportion.

An active mutual fund tries to maximize the returns by continuously buying and selling stocks while index fund simply buy the stocks of underlying index and doesn’t buy/sell unless there is any change in the index itself. Since there are no frequent buy/sell, it can save a lot of money for index funds investors.

Note: An index is a group of securities defining a market segment.

Its is to be noted that active funds tries to beat the underlying benchmark while Index fund tries to match the return offered by underlying Index. these are also called passively managed funds, since they do not required active management.

List of Different NSE Indices:-

NSE Indices Limited, owns and manages a portfolio of 67 indices under NIFTY brand as of September 30, 2016, including NIFTY 50. NIFTY indices are used as benchmarks for products traded on NSE. Investors can invest in Index Funds of any the below indices, for which there is an Index fund or ETF available as per their investment goals and risk appetite.

Who Should Invest In Index Funds?

In case of actively managed funds, the fund manager makes buy/sell stocks from fund’s portfolio as per his understanding thereby adding an added extra element of risk. Since Index funds doesn’t not buy/sell based on individual perception, such element of risk is not there.

Note: Passive management now accounts for over 50% of all assets for U.S. stock-based funds.

If an investor is ready to participate in equity investment , want predictable returns and doesn’t want to take risk associated with active stock selection or fund manager risk with active mutual fund. He/She can choose an Index Fund for long term wealth building.

Benefits of Index Funds Over Active Funds

The below table will provide the main benefits of equity Index funds over actively managed equity funds in nut-shell. It clearly suggest Index funds scores higher when it comes to low risk, low cost ,long term investing and wealth building strategy.

FatorActive FundIndex Fund
Expense RatioHighVery Low
Fund Manger RiskHighNone
Market RiskHighHigh
Performance compared to IndexMajority Under performComparable
Portfolio ChurnHighLow
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Best Index Funds In India

While evaluating Index fund four criteria are used: returns, total expense ratio(%), fund size and diversification . an investor should compare the index mutual funds on the four parameters listed above. Below is the list of top 5 best direct index mutual with a proven track record and who has consistently beaten category average returns in last 5 years:

Fund Name5 Yrs Anlsd %Expense Ratio (%)
HDFC Index Fund Sensex Plan-Direct Plan12.34%.10%
Tata Index Fund Sensex Direct Plan12.32%.05%
Nippon India Index Fund – Sensex Plan – Direct Plan – Grow12.11%.10%
IDFC Nifty Fund – Direct Plan – Growth11.69%.15%
LIC MF Index Fund-Sensex-Direct Plan Growthoption11.66%.57%
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Factors To Consider Before Investing In Index Fund In India

here are few important factors which you should consider before zeroing in on Index funds for long term investments.

Expenses Ratio: Expenses ratio is the small percentage of the total assets of fund , charged by fund houses for services provided as fee. The biggest advantage of index fund is their extremely low expense ratio. Since there is no active buying/selling of stocks to beat the underlying Index, there is no need to do individual stock picking for thereby reducing the overall fund management cost.

Tracking Error: Tracking error is the deviation of the difference in returns
between the Index fund and its benchmark Index. Always try to pick Index funds which has low tracking error.

Diversification: The primary purpose of Index fund is to provide long term wealth creation with limited risk, always try to invest in Index funds which provide broader market exposure rather than investing in obscure indices based Index funds. Its always better to include exposure to international market such SPX 500 in your portfolio for 10-15% of total asset values.

Investment Horizon: Index investing is suitable for long term wealth creation and only suggested to people looking to invest in market for long term ideally 7 years+ to reap the maximum benefit.

Taxation on Index Fund Investments: When you sell units of index funds, you earn capital gains, which are taxable. The rate of taxation totally depends on how long you stayed invested in index funds.

Capital gains you make during the holding period of up to one year are called short-term capital gains (STCG). STCG is taxed at a rate of 15%. Similarly, capital gains you earn after a holding period of more than one year are called long-term capital gains (LTCG). LTCG over Rs 1 lakh is taxed at 10% without the benefit of indexation.

Frequently Asked Questions About Index Fund

Q. Can you lose money in an index fund?

All mutual funds investments are subjected to marked risk. being said thats, Its highly unlikely that you will lose all your money in long term. You will not make large gain similar to individual stocks,however you can expect 10-12% annual return Y-o-Y basis.

Q. How do I invest in index fund?

You can invest in index fund from the mutual fund houses who deals in that category or via platform like Grow, ETmoney. The process is digitized for the benefit of common investors.

Q. Will index fund make you rich?

No, you will not make lot of money unlike bitcoin , however index fund investments are for consistent wealth compounding. It takes few decades before wealth can be accumulated via index funds.

Q. is it a good time to buy index fund?

Its all about time spend in market rather than timing the market. The best time to invest in index fund was 10 years ago and second best is now.

Q. Why index funds are not popular in india?

This is due to the fact that active fund managers are still able to deliver higher returns compared to underlying benchmark and almost zero to no promotions by mutual fund houses due to minimal commissions/charges.

Q. Do index fund charges fee?

Yes, Index fund do charges fee, however its very less compared to actively manged funds offered by same fund houses.

Further Reading suggested:-

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