From Risk, Returns, To Taxation & Types: All You Need To Know About Index Funds

It was way back in 1976 when the founder and CEO of American investment management firm The Vanguard Group, John Clifton Bogle created the first-ever index fund.

The American investor, business magnate, and philanthropist is credited for introducing the Vanguard 500 Index Fund, which simply tracked the S&P 500 Index, which is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States and is of the most followed indices.

Fast forward to today, index funds have diversified into different types and categories, and evolved over time in the mutual fund industry.

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Even Warren Buffett, the legendary investor, has on multiple occasions recommended people to invest in low cost index funds, and remains strongly in favour of them.

But what exactly are index funds? Should you invest in them? What are the risks, returns, etc associated with them?

Eager to know? Lets take a deep dive and help you understand the concept of Index Funds.

What Are Index Funds?

Index Funds are passive mutual funds that mimic popular market indices. Unlike active funds wherein the fund managers keep tweaking the portfolio by selling and buying stocks regularly, index funds only remove stock if it gets removed from that index.

So, the fund manager doesn¡¯t play an active role in selecting industries and stocks to build the fund¡¯s portfolio, and instead simply invests in all the stocks that make up the index to be followed, whether its S&P 500, Nifty50, Sensex or any other index.

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The weightage of the stocks in the index fund closely matches the weightage of each of the stocks in the index. Through passive investment strategy, the fund manager simply copies the chosen index while building the fund¡¯s portfolio and tries to maintain the portfolio in sync with its index all the time.

If the weight of a stock within the index changes, the fund manager buys or sells units of that stock so as to have its weight in the portfolio aligned to that of the index.

Tracking Error

While index funds do follow the chosen index in terms of investment strategy, they don¡¯t always produce the exact same returns as that of the index. This is due to tracking error.

Tracking error occurs because it is not always easy to hold the securities of the index in the exact same proportion, and the transaction costs are usually incurred by the fund in doing so. But despite tracking error, index funds¡¯ returns are quite close to the index¡¯s returns.

Mathematically, tracking error is the annualized standard deviation of the tracking difference of an index fund. So, the returns of index funds tend to be at least similar to the followed index returns, if not the same.

Categories Of Index Funds

Index funds work pretty much similar to other mutual funds. They take your money and invest in the stock market. However, how they invest and manage the portfolio is what sets them apart as a category, since they follow the investment strategy of their index.

When you invest in index funds, the fund manager simply allocates the money to stocks that are part of the index and in the same proportion as the index.

For example, a SENSEX based fund will buy all the 30 stocks that are part of the SENSEX and in the same proportion. Whenever a stock is removed from the index, and the new stock gets added, the fund will also replicate the change in its portfolio. Similar is the case for Nifty 50, Nifty next 50, and other indices.

Now let us look at some of the popular categories on Index Funds in India.

Also Read: Do Mutual Funds Invest In Stocks Only?

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1. Broad Market Index Funds

A Broad Market Index Fund aims to replicate a large segment of the investable stock market. For instance, an Index Fund tracking the NIFTY 500 index is a Broad Market Index Fund because it gives investors a larger exposure to stocks across different sectors and market caps when compared to some other index that focuses on a smaller segment, such as NIFTY50 or Sensex. S&P 500 and NASDAQ composite are also examples of broad market index funds.

2. Market Capitalization Index Funds

A majority of stock market indices are weighted by their market capitalization. For instance, the NIFTY 50, the SENSEX, the NIFTY Next 50, NIFTY Smallcap 250, etc are all examples of indices that are market-cap weighted.

3. Equal Weight Index Funds

Simply put, an equal-weight index is an index where every stock in the index carries the same weight. Herein, instead of a few large stocks occupying the majority of weight and that¡¯s why anchoring most of the performance, equal weight is given to all the stocks in the equal weight index to avoid such preferential treatment. So, no single stock can define the trend of that index.

3. Sector-Based Index Funds & ETFs

Many investors invest in sector-based funds or in ETFs (Exchange Traded Funds). The idea behind them is to invest in businesses belonging to the same industry or sector. For instance, there are sector-specific Index Funds and ETFs in banking, technology, healthcare, infrastructure, consumption, etc.

These sectoral funds generally cater to broader categories, but that¡¯s not all. There are Index Funds which also offer a much narrower category to choose. For instance, a banking sector Index Fund would be based on the broader banking category, but investors can even get to choose a PSU bank only or a private bank only Index Fund as well. Some examples of sectoral index funds are ICICI Prudential Technology Fund,Mirae Asset Healthcare Fund Regular Growth,Tata Digital India Fund Regular Growth etc.

An ETF,i.e exchange traded fund, pools the financial resources of several people and use it to purchase various tradable monetary assets such as shares, debt securities such as bonds and derivatives. ETFs share characteristic features of both shares and mutual funds. They are generally traded in the stock market in the form of shares produced via creation blocks.

So, changes in the share price of an ETF are dependent on the costs of the underlying assets present in the pool of resources. If the price of one or more asset rises, the share price of the ETF rises proportionately, and vice-versa. The value of the dividend received by the share-holders of ETFs would depend on the performance and asset management of the concerned ETF company.

4. International Index Funds

As their name suggests, international index funds invest in stocks of companies listed outside of India. Through these funds, you can invest in some of the biggest companies in the world. These funds also add a layer of geographical diversification to your portfolio and help you expand your portfolio to seek additional growth opportunities.

Some of such funds are ICICI Prudential US BlueChip Equity Direct-Plan-Growth,PGIM India Global Equity Opportunities Fund Direct-Growth,Edelweiss Greater China Off-Shore Fund Direct-Growth etc.

Why Invest In Index funds?

1. Relatively Lower Fees

As index funds replicate an index, there is no need for a team of analysts for research and helping fund manager find stocks. Even fund managers don¡¯t need to put their expertise in portfolio construction as its the index which has to be followed with minimal tracking error.

Moreover, the passive nature of index funds means there is no active buying and selling of stocks. All these factors make the expense of managing an index fund low, and this translates into low fees for investors through low expense ratio.

2. Broad Market Exposure

As the major indices are created to be a representation of the overall market, they cover all the key sectors of the economy. And within each sector too, the relevant stocks are covered.

Also, investing money in the same proportion and stocks as an index makes sure you get a portfolio that is diversified across stocks and sectors. This reduces overall risk too, as all sectors or stocks seldom go down at the same time. Moreover, you don¡¯t miss out on any major sector, hence increasing the return potential as well.

For example, when you invest in a Nifty 50 index fund, you get to invest in 50 stocks spread across different sectors, ranging from financial services to pharma.

3. No Scope Of Bias

As Index funds follow an automated, rule-based investment methodology, the scope of bias isn¡¯t present. They are passive natured funds, and the fund manager therefore has a defined mandate regarding the stocks to choose, as per the index to be followed. This removes the scope of human bias/discretion while making investment decisions.

What about the risk?

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Also Read: Debunking Mutual Fund Myths

Since index funds track a market index and are passively managed, they are less volatile than the actively managed equity funds. Hence, the overall risks are lower. During a market rally, index funds returns are usually good, whereas a market slump is likely to make your fund bleed too.

Also pay attention to the tracking error. The lower the tracking error, the higher the chances of the fund having similar returns to the followed index.

Taxation Of Index Funds

As index funds belong to equity funds¡¯ category, they are subject to capital gains tax.

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Upon redeeming the units of an index fund, you earn capital gains, which will be taxable. The rate of tax depends on the holding period .For short term, STCG tax of 15% is levied, whereas for long term, LTCG tax of 10% is levied on gains above Rs 1 lakh without indexation benefits.

Who should invest in Index Funds?

Since Index Funds track a particular market index, the returns are similar to those offered by the index, such as Sensex or Nifty50. So, investors who prefer predictable returns and wish to invest in the equity markets without taking a lot of risks can go for these funds. Also, index funds are passively managed, and the returns would likely be closer to the index¡¯s returns.

So those who are fine with such returns tied to the index, can opt for them. However, do not generally expect over the top returns when compared to the chosen index's funds. The returns of index funds, again, are likely to be closer to the index's funds.

Do not forget to factor in the risk, returns, tracking error, taxation etc before investing in index funds or any other mutual funds category. And avoid blindly following or copying someone else¡¯s strategy or advice. Investing should ideally depend on your risk appetite, surplus available to invest, goals tied to the investment and the investment horizon. There isnt a one size fits all strategy or rule, so ensure to factor in all the mentioned aspects to ensure you are on the path of wealth creation.

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