What Are Index Funds?

There are hundreds of investment options, if not thousands, in the Indian stock markets. To many options confuses average investors as they don’t have a clear idea on how to invest without taking too much of risk. Mutual Fund is one instrument that offers some kind of risk mitigation with respect to market risks to retail investors. Through this article, investors will get to know about the following,

In this article, we will cover,

-What is Index Funds?
-How do Index Funds Work?
-History of Index Funds
-Index Funds vs Mutual Funds
-Pros & Cons of Index Funds
-Who should invest in Index Funds?
-How to select Index Funds for Investments?
-Top Index Funds in India

What Are Index Funds?

An index is a group of securities chosen to track a particular investment theme such as a market, asset class, sector, industry, etc. The popular indices in India are stock indices like BSE Sensex, NSE Nifty, and Bank Nifty. An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index. It invests in stocks that are part of the index in the exact same proportion as the stocks in the index itself. To be more precise, index funds are such funds that are there to replicate the performance of the market indices. They are also known as the passive funds as these funds don’t require a large degree of active monitoring as these funds are not designed to outperform the market, rather these funds are designed to replicate the performance of the index. Index funds are popular in the US and in the developed world but it’s at the nascent stage in India.

How do Index Funds Work?

Index funds track a benchmark trend like the Nifty or Sensex. The portfolio will have the replicate of the stocks that comprise respectively Nifty or Sensex, in the same proportions. An index is a group of securities defining a market segment. Some of the most popular indices in India are BSE Sensex and NSE Nifty. Since index funds track a particular index, they fall under passive fund management. The fund manager according to follow the underlying benchmark. An index fund’s role is to match its performance to that of its index. Index funds typically deliver returns more or less equal to the benchmark. However, there can be a small difference between fund performance and the index. This is referred to as the tracking error. The fund manager must work towards bringing down the tracking error as much as possible. In the case of a weighted index, fund managers frequently stabilise the percentage of the securities to ensure making a presence in the benchmark.

History of Index Funds:

Index funds came into theoretical existence in 1960, the concept was suggested by Edward Renshaw & Paul Feldstein. They thought of a simple yet logical concept. It was, what if there was no need of managing an investment company, i.e. unmanaged investment company.

Later in the 1970s, it was found that mutual funds were not performing as per the expectation of the market and the performances of the funds were dicey.

John Bogle in 1975 started the first index of an investment trust. His fund surged to $100 billion from a marginal value of $11 million in 24 years duration. The increase in fund size suggests that the people had an understanding of the value of investing in index funds.

Index funds in India have less penetration compared to typical mutual funds and not only that the penetration of index funds in India when compared with the US, but the UK is also quite low.

Index Funds vs Mutual Funds:

Although Index funds are itself one type of mutual fund, it would make sense if we understand that how an index fund is similar and as well as dissimilar when compared to a mutual fund.

Basis	Mutual Fund	Index Fund
Definition	Mutual Fund is a fund, created to pool the money from different retail investors or even institutional buyers to buy securities. These funds are usually managed by a team of professionals who have experience in managing funds worth 1 crores or more.	An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index in the exact proportion as the stocks in the index
Rule of investment	There is no predefined rule of investment as such. The only objective is to maximize the performance of the fund based on the simple fund objective	There is a predefined rule and the fund needs to replicate the benchmark index as it is
Expense ratio	Due to efforts put in by the fund manager, there is a high expense ratio. Expense ratio could be in the line of 1-2%	Very low to nil expense ratio. The expense ratio could be in the line of 0.20-0.4%
Growth of Fund	May or may not outperform the market indices	Will closely replicate the market indices with marginal tracking error
Ease in Liquidating	Mutual Funds as a scrip is easy to liquidate	Index Fund as a scrip is easy to liquidate
Tax Deduction	ELSS Mutual Fund/ Tax Saving Mutual Funds provide tax deduction under the section 80c, IT Act 1961 but there are many funds which do not	Index funds are not tax-exempt

Pros & Cons of Index Funds:

Pros of Index Funds:

1. Returns generated by an index fund is in line with the return generated by the index itself thereby eliminating the risk of underperformance of the fund
2. Risk is low when compared with other types of funds and individual stocks
3. The expense ratio is very less and in many funds exit load is zero
4. As there is a predefined rule, therefore there is very less chance of human error due to any investment strategy

Cons of Index Funds:

1. Returns generated by index fund in India is less than the actively-managed funds in India
2. An index fund is subject to tracking error, meaning due to lag in tracking events related to the index, an index fund may incur a lag impacting the performance of the funds. In fact, this is the maximum risk an index fund could have.  

Who should invest in Index Funds?

Usually, risk-averse investors who want predictable returns should invest in index funds, the reason being that the performance of the index fund can be predicted with a better degree of accuracy, it doesn’t require excessive tracking and doesn’t have the risks associated with actively-managed funds.

How to select Index Funds for Investments?

Even though index funds are passive funds, still investors need to know how to select the best index fund for their investment. Following are a few parameters on which an index fund can be assessed for investments:

A. Investment horizon

Index funds are basically suitable for individuals who have a long-term investment horizon. the fund experiences a lot of fluctuations during the short-run which averages out in the long-run of saying more than 7 years in order to give returns in the range of 10%-12%. Those who choose index funds need to be prepared to stick around at least for the said period to enable the fund to realize its full potential.

B. Low expense ratio

Investors should look out for low expense ratio index funds as the lower the expense ratio the better returns investors would get from the fund.

C. Low tracking error

The integrity of index funds solely depends on the tracking error, the lower the tracking errors, the better will be the integrity of the fund and hence the desired performance would be delivered by the fund. Investors should also understand that it is very difficult to identify tracking errors easily. Therefore a better proxy of tracking error is past performance. So if the performance of the fund is upto the mark then the fund is doing all necessary activities to catch up with the index in consideration.

D. Risk

Since index funds map an index, they are less prone to equity-related volatility and risks. Index funds are amazing options during a market rally to earn great returns. However, you need to switch to actively-managed funds during a slump. It’s because index funds may lose higher value during a market downturn. It’s always advisable to have a mix of actively-managed funds and index funds in your portfolio.

Top Index Funds in India:

	UTI Nifty Index Fund – Direct	ICICI Prudential Nifty Next 50 Index Fund – Direct	HDFC Index Fund – Sensex Plan – Direct	HDFC Index Fund – Nifty Plan – Direct
Inception	1st Jan 2013	1st Jan 2013	1st Jan 2013	17th July 2002
Net Asset	983 crore rupees	300 crore rupees	259 crore rupees	418 crore rupees
Fund Strategy	The fund invests in Nifty 50 Index companies, reflect the movement of Nifty 50 by passive investments	The fund invests in Nifty Next 50 Index companies, reflect the movement of Nifty Next 50 by passive investments	The fund invests in Sensex Index companies, reflect the movement of Sensex 30 by passive investments	The fund invests in Nifty 50 Index companies, reflect the movement of Nifty 50 by passive investments
Type	Open-Ended	Open-Ended	Open-Ended	Open-Ended
Exit Load	0	0.25% for redemption within 7 days	0.25% for redemption within 3 days	0.25% for redemption within 3 days
Expense Ratio	0.12%	0.44%	0.15%	0.3%
Benchmark	Nifty 50 TRI	Nifty Next 50 TRI	S&P BSE Sensex TRI	Nifty 50 TRI
Performance:
1-year return	13.26%	2.08%	16.81%	13.27%
3-year return	13.15%	14.16%	13.55%	12.93%
5-year return	14.52%	20.36%	14.22%	14.43%
Since Inception	12.19%	15.72%	12.84 %	15.28%

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