Last Updated on May 24, 2022 by Aradhana Gotur

In the long term, the journey of the market indices is upward. While the kind of growth they have exhibited over the years are attractive to investors, one cannot directly buy an index because they are only mathematical constructs. Index funds give investors the opportunity to invest in the index. They are a type of mutual funds that invest in stocks of companies that form part of a benchmark index. They are essentially equity-oriented in nature and mirror the benchmark index they track. In this article, we deep dive into what is index fund, how it works and how to invest in index funds.

What are index funds?

Index funds are open-ended and equity-oriented mutual fund schemes that invest at least 95% of their total portfolio in securities of a particular index they track. They are named so because they mirror the benchmark index, that is, the composition of the fund is a replica of the composition of the index that the fund tracks, and in the exact same proportion. These funds are passively managed mutual funds since the fund managers only imitate the underlying index when creating the fund portfolio. Therefore, index funds aim to match the return of the underlying benchmark index, not beat it.

Index funds are open-ended and equity-oriented mutual fund schemes that invest at least 95% of their total portfolio in securities of a particular index they track. Click To Tweet

How do index funds work?

In an index fund, firstly, a benchmark index is chosen. Thereafter, the fund manager copies the portfolio composition of the index and invests the fund corpus in the same securities held by the underlying index. The proportion of holding of each security also matches that of the tracked index.

For example, say an index fund uses Nifty 50 as its benchmark index. Nifty 50 contains stocks of 50 companies. The Nifty 50 index fund would also invest in the same stocks as the Nifty 50. Moreover, the weightage of each stock would also be in sync with the Nifty 50 index. For example, if RIL constitutes 9.7% of the Nifty, the Nifty 50 index fund would also have RIL comprising 9.7% of its total portfolio. 
Should the composition or the weightage of securities in the index change during the bi-annual review, the fund manager would effect the same change in the fund to always retain the match with the underlying index. Thereafter, as the underlying index, the Nifty 50 in the aforementioned example, performs, the index fund also yields similar returns.

Benefits of index funds

The benefits of index funds can be highlighted in the following points:

Capture market growth

Benchmark indices are a reflection of the market or a market segment. When an investor invests in index funds that mirror a benchmark index, they are able to capture the potential of entire markets through investment in just one product.

Diversification

An index contains a range of securities diversified across top companies and sectors in its portfolio. So, index funds tracking a particular index also diversifies the portfolio in the same manner as that of the underlying index. This broad diversification also helps one minimize market risks in the portfolio.

Low expense ratio

One of the highlighting features of an index fund is its low expense ratio. Since the fund is passively managed, the fund management fee is minimal. This brings down the Total Expense Ratio (TER) and allocates most of your investment for maximum gains.

Low cost of investment

An investor buying all the stocks in a benchmark index will require huge capital. However, through index funds, investors can own all the components of the index in the same weightage but at a fraction of the cost.

Limitations of index funds

Though index funds have their benefits, there are certain limitations too, which you should keep in mind. These limitations include the following:

Not beneficial in a market slump

Index funds can give you attractive returns when the market is in an upswing. However, in a slump or when the market is in a bearish phase, index funds, usually, do not deliver good returns. Since they imitate an index, if the value of the index falls, you might suffer capital erosion. Index funds generally are long-term investments.

Index funds can give you attractive returns when the market is in an upswing. However, in a slump or when the market is in a bearish phase, index funds, usually, do not deliver good returns. Click To Tweet

Possibility of a tracking error

Though the fund manager tracks the underlying index, the returns generated by the index fund may not match the returns of the benchmark index to the decimal point. This is because there is a technical error called a tracking error and fund managers continuously aim to keep this tracking error as close to zero as possible.

Returns do not beat the index

Index funds aim to match the returns of the benchmark index. They do not outperform the benchmark index and generate alpha. Even when the markets are rallying and there is a scope to beat the benchmark, the returns of the index fund is limited. Therefore, this does not bode well with investors looking to earn maximum returns on their investments.

How to invest in index funds?

Index investing is fairly simple. Given index funds simply replicate the underlying index, all index funds that track the same index would have the same composition, which is the index. This greatly narrows the choice of funds for the investors. 

All that an investor needs to do is figure out which index they want to invest in and then make the pick. This can be done by comparing the funds from various fund houses on just two simple parameters, they are expense ratio and tracking error. The tracking error is a marginal difference in the returns of the fund from the returns of the market caused by technical factors such as rebalancing activity and associated costs. The lower the tracking error, the more close to benchmark returns the yield of the fund is.

If you are wondering how to invest in index funds, you have choices. You can invest in index funds online or offline, just like you would invest in any equity-oriented mutual fund. Moreover, investments can be made in one lump sum, or, systematically in the form of SIPs. It is, therefore, easy to invest in index funds.

Who should invest in index funds?

Investors looking to diversify their portfolio and invest as per a particular index can choose to invest in an index fund. While the funds are known to provide stability of returns, in line with market performance, you should remember that index funds are ultimately equity-oriented mutual fund schemes. As such, you need a healthy risk appetite if you are investing in these schemes. Investors with a medium to long term investment avenue may consider these funds for getting good returns on investments as indices usually give good returns over the longer term.

Taxation of index funds

Being equity-oriented schemes, index funds attract equity taxation which is as follows:

  • Returns earned on redemption within 12 mth are called short-term capital gains. Such gains are taxed at 15%
  • Returns earned on redemption after 12 mth are called long-term capital gains. Such gains are tax-free up to Rs 1 lakh. Returns exceeding Rs 1 lakh, however, are taxed at 10%
  • If you opt for the dividend option, the dividend earned would be added to your taxable income and taxed at your income tax slab rates

Understand the index fund meaning before you opt to invest in them. Also, remember the pros and cons of investing in index funds. Align your investment with your risk appetite and financial goals and then invest in these schemes for achieving financial freedom.