What are Index Funds?
An index fund is a form of a mutual fund or exchange-traded fund (ETF) that invests in the components of a financial market index, such as the Nifty 50 or the Sensex 30 Index. A mutual fund that invests in indexes is considered to offer broad market exposure, low operational costs, and low portfolio turnover. These funds will always track their benchmark index regardless of market conditions.
Index funds are often regarded as the optimal core holdings for retirement accounts such as the Provident Funds account and the National Pension Schemes.
Mr. Warren Buffett, the legendary investor, has advocated index funds as a safe harbor for retirement money. Rather than investing in individual stocks, he has stated that it makes more sense for the average investor to purchase all of the large and well-established companies by investing in the Nifty 50 and Sensex 30 businesses through an index fund.
How do Index funds operate?
The term “indexing” refers to a type of passive fund management. Rather than actively stock picking and market timing (that is, selecting securities to invest in and planning when to purchase and sell them), a fund portfolio manager constructs a portfolio whose holdings reflect those of a specific index. The theory is that by replicating the index’s profile – the stock market as a whole or a large section of it – the fund’s performance will also be replicated.
Investing in an index fund is a passive investment strategy. Active investing, on the other hand, is implemented through actively managed mutual funds – those with the security-picking and market-timing portfolio managers outlined above.
What to consider before Index Investing?
Although Index Investing is one of the easiest & safest forms of Investing. They do carry a certain amount of risk and thus need to be studied before investing. So, what should we check in Index Investing?
Cost of Investing
The expenditure ratio is a critical criterion when comparing two index funds that track the same index. Two funds that track the same index will have comparable results. Between the two, the top index fund has a lower expense ratio and produces higher returns.
According to these regulations, the maximum total expense ratio (TER) is 2.5 percent for the first Rs. 100 crore of average weekly total net assets (AUM), 2.25 percent for the next Rs. 300 crore, 2% for the next Rs. 300 crore, and 1.75 percent for the remaining AUM.
An acceptable expense ratio for an actively managed portfolio is between 0.5 and 0.75 percent, while more than 1.5 percent is considered high these days. The normal ratio for passive or index funds is around 0.2 percent, although it can be as low as 0.2 percent or less in some situations.
Risk of Investing
Index funds insulate investors from market risks while offering competitive returns. However, even the best index fund may lose value during a market slump. It is prudent to have a mix of active and index funds in one’s portfolio.
The risk and return of an Index Fund are directly correlated to the weightage & portfolio allocation. Hence, an optimally allocated fund phases well during the various market cycles.
Frequently, index funds are unable to replicate the performance of their underlying index exactly. Usually, a Nifty index fund tries to clone the Nifty 50. But, the same cannot be 100% perfect. Because of tracking errors which will be minimum in most cases.
Thus, we see performance discrepancy is due to the index’s tracking inaccuracy. Select the fund with the lowest tracking error at all times. The lowest tracking error reflects the least departure from the index’s returns, implying a more successful fund.
Track record of the Fund manager who actively manages the fund is very important. This shows the Professional fund manager’s ability to wave of market volatility and outperform the industry average. In the case of Passive Investing, they are the clone of an Index or another actively managed fund.
Index funds are best suited for investors who have a long time horizon for their investments. To maximize the fund’s overall return potential, investors need to commit to a minimum of 5 to 10 years of investment period. The long term compensates for short-term volatility and provides a healthy return of 10% to 12%.
Since index investing is mostly passive investing, no need for active participation from the investors. Thus, a buy-and-hold strategy as long as he/she is capable of is suggested.
Advantages of Index Investing:
- Index investing offers diversification and reduces risk.
- Offers low cost-to-income ratios.
- Limited knowledge required
- Significant long-term returns.
- Limited Active participation.
- It is ideal for investors who prefer to buy and hold.
- Investors pay lower taxes.
- Saves time.
Disadvantages of Index Investing:
- Vulnerable to market fluctuations and crashes.
- There is no human component.
- Gains are restricted.
- An investor holds no control over the Fund hence no control over the risk-return.
- Limited flexibility.
Passive Index Investing V/s Active Mutual Fund Investing:
Actively managed investments are those in which a manager or broker actively buys and sells individual securities in order to outperform a market index. While they may perform well in the short term, the majority of them underperform the market after a couple of years. Index funds, on the other hand, typically generate larger returns over longer time periods. This is because an index fund, a form of a mutual fund or exchange-traded fund (ETF), monitors a specified set of investments and seeks to achieve the same returns as those investments, making it passively managed.
Index funds eliminate the need for extensive study and analysis to identify stocks that may outperform others over a specified time period. Due to this passive nature, there is reduced risk and associated fees and expenses.
Although nothing can beat the returns provided by a well-experienced fund manager, concentrated portfolio. Finding such a professional fund manager who could give an above-average return consistently is like finding gold in a silver mine.
Index Investing – Direct Plan V/s Regular Plan:
A direct plan is one that you purchase from the mutual fund firm directly (usually from their own website). A regular plan is one that is purchased through a financial advisor, broker, or distributor (intermediary). In a traditional model, the mutual fund firm compensates the middleman with a commission. This is then recouped as an expense.
SEBI introduced direct plans for mutual funds in 2012. This was done to enable investors to purchase mutual funds directly from the fund manager. The same mutual fund manager manages both the direct and regular plans. They, too, invest in the same assets. However, the primary distinction is that, in a normal plan, the fund house charges a distribution fee in the form of a commission. whereas there is no such commission or fee in the direct plan.
Direct Plan has no middlemen, third-party agents, or brokers. Hence, they have no additional fees and carry a low expense ratio. And, regular plans provide investment advice alongside and also carry a bit higher expense ratio.
Top 10 Best Performing Index Funds (Direct Plan):
|Scheme Name||AUM (Rs. Cr)||1 Year||2 Year||3 Year||5 Year|
|Nippon India Index Fund - Direct Plan - Sensex Plan - GrowthIndex Funds/ETFs||240.07||24.62%||21.98%||20.27%||18.53%|
|HDFC Index Fund - Direct Plan - Sensex PlanIndex Funds/ETFs||2,914.77||24.63%||21.75%||20.18%||18.52%|
|Tata Index Fund - SENSEX - Direct PlanIndex Funds/ETFs||112.26||23.81%||21.50%||20.01%||18.40%|
|LIC MF Index Fund - Sensex Plan - Direct Plan - GrowthIndex Funds/ETFs||46.8||24.40%||21.68%||19.99%||18.08%|
|IDFC Nifty Fund - Direct Plan - GrowthIndex Funds/ETFs||356.66||26.22%||22.89%||20.24%||17.96%|
|Taurus Nifty Index Fund - Direct Plan - GrowthIndex Funds/ETFs||1.71||26.02%||23.15%||19.84%||17.91%|
|UTI Nifty Index Fund - Direct Plan - GrowthIndex Funds/ETFs||5,841.00||26.55%||22.59%||20.15%||17.89%|
|HDFC Index Fund - Direct Plan - Nifty 50 PlanIndex Funds/ETFs||4,433.94||26.47%||22.42%||20.00%||17.82%|
|Nippon India Index Fund - Direct Plan - Nifty Plan - GrowthIndex Funds/ETFs||427.71||26.45%||22.48%||20.02%||17.79%|
|Tata Index Fund - NIFTY - Direct PlanIndex Funds/ETFs||222.92||26.35%||22.43%||20.01%||17.77%|
Top 10 Best Performing Index Funds (Regular Plan):
|Scheme Name||AUM (Rs. Cr)||1 Year||2 Year||3 Year||5 Year|
|Motilal Oswal Nasdaq 100 ETF (MOSt Shares NASDAQ 100)Index Funds/ETFs||6,272.86||24.51%||35.97%||36.15%||27.54%|
|Motilal Oswal Nasdaq 100 ETF (MOSt Shares NASDAQ 100)Index Funds/ETFs||3,785.63||24.51%||35.97%||36.15%||27.54%|
|ICICI Prudential NV20 ETFIndex Funds/ETFs||28.92||32.29%||31.56%||24.94%||21.97%|
|UTI SENSEX Exchange Traded FundIndex Funds/ETFs||19,236.71||24.86%||22.15%||20.54%||18.89%|
|HDFC Sensex ETFIndex Funds/ETFs||148.67||24.85%||22.10%||20.50%||18.86%|
|HDFC Sensex ETFIndex Funds/ETFs||110.09||24.85%||22.10%||20.50%||18.86%|
|LIC MF ETF - SensexIndex Funds/ETFs||557.06||24.66%||22.03%||20.46%||18.86%|
|ICICI Prudential Sensex ETFIndex Funds/ETFs||239.24||24.86%||22.15%||20.51%||18.76%|
|Kotak Sensex ETF FundIndex Funds/ETFs||20.86||24.61%||21.88%||20.25%||18.61%|
|IDFC Sensex ETFIndex Funds/ETFs||0.86||24.21%||21.69%||20.14%||18.61%|
How to Invest in Index Funds?
The easiest way to Start Investing in an Index Fund is to own a DEMAT account.
Do not own a Demat account yet? Then worry not! Click on the bellow button and create your own Demat account at the finest brokerage service provider in India.
Step1: Open a DEMAT account.
Step 2: Find the Index Fund you prefer. (You can also refer to the list mentioned above).
Step 3: Invest as in SIP or Lumpsum.
Reduced expense results in increased performance. Passive funds, proponents contend, have outperformed the majority of actively managed mutual funds. Indeed, the bulk of mutual funds does not outperform their benchmarks or broad market indices.
According to a report by SPIVA (S & P Indices vs Active), the S & P BSE 100 index generated a three-year compound annual growth rate of 3.13 percent, a five-year compound annual growth rate of 5.6 percent, and a ten-year compound annual growth rate of 8.13 percent. Though these are from before the current bull run, let us examine the contrast as of that date.
According to the research, the performance of Indian equity-oriented funds in the large-cap category over the last three years has been 1.31 percent, 4.63 percent over the last five years, and 7.98 percent over the last ten years. That is, the index has outperformed the average performance of the large-cap mutual fund basket.
Moving to a wider basket, the S & P BSE 200 index delivered annualized returns of 2.89 percent, 5.83 percent, and 8.32 percent during the last three, five, and ten years, respectively. When compared to the average of the ELSS basket, the comparable percentages are 0.29 percent, 4.98 percent, and 9.22 percent.
The common thread running across these two sets of data is that the longer the time period compared, i.e., 5-year over 3-year and 10-year over 5-year, the better the performance of actively managed funds. The consequence is that passive funds have performed better over the last three to five years, whereas active funds have performed better over a longer period of time.
By contrast, passively managed funds make no attempt to outperform the market. Rather than that, their method tries to equal the market’s entire risk and return on the idea that the market always wins.
Over time, passive management that results in favorable performance is more likely to be true. Active mutual funds perform better over shorter time periods. According to the SPIVA Scorecard, only around 60% of large-cap mutual funds underperformed the index over a one-year period. In other words, almost two-fifths of them are able to overcome it in the near run.
Additionally, carefully managed money is required in other categories. For instance, over 86% of mid-cap mutual funds outperformed the S & P MidCap 400 Growth Index over the course of a year.
Frequently Asked Questions (FAQs):
- Is Index Fund Taxed? If so, How?
Answer: Index funds are a type of equity investment. But, index funds are taxed differently depending on their holding period. Short-term capital gains are realized upon redemption of your units within a one-year holding period. Gains on these investments are taxed at a fixed rate of 15%.
Long-term capital gains are those earned on the sale of fund units after a one-year holding period. Gains of up to Rs 1 lakh per year are tax-free. Any gains in excess of this amount are subject to a 10% tax, and indexation is not permitted.
- Do Index Funds provide Dividends?
Answer: An index fund is a type of mutual fund that invests in all of the companies that comprise the index. As a result, if those companies pay dividends, the fund does as well. It is another matter if you opt to cash out the dividend (Dividend Fund) or reinvest it in the same fund (Growth Fund).
The dividends paid by an index fund are added to your total income and taxed at your marginal rate of income tax. This is referred to as the traditional approach of dividend taxation in the hands of investors.
Disclaimer: All the information on this website is published in good faith and for general information purpose only.