What are Index Funds?

Diversification is an important component of an investment portfolio. Investors aim to diversify their portfolios by investing in several asset types such as equity, debt, real estate, gold, and so on. They strive to diversify even within each asset class to reduce risks. Let’s look at what Index Funds are and how they help investors.

What are Index Funds and how do they work?

An Index Fund, as the name implies, invests in equities that replicate a stock market index such as the NSE Nifty, BSE Sensex, and so on. The portfolio of an Index fund is constructed based on clearly defined parameters and do not have a fund manager or an analyst team to decide which stock to invest in. This significantly reduces the cost incurred while managing these funds and lead to lower expense ratios.

Most Indexes in India are constructed using a float-adjusted, market capitalization weighted methodology, wherein the level of the index reflects the total market value of all the stocks in the index relative to a particular base period. The methodology also takes into account constituent changes in the index and corporate actions such as stock splits, rights issuance, etc., without affecting the index value.

Assume that an Index Fund follows the NSE Nifty Index. As a result, this fund’s portfolio will have 50 stocks with identical weights as in the NSE Nifty Index. The index fund makes certain that it invests in all of the securities that are part of the index. An actively managed mutual fund aims to outperform its underlying benchmark, whereas an index fund, which is passively managed, aims to match the underlying index’s returns .

Rebalancing of index fund

Rebalancing the Index plays a crucial role in ensuring stability of the index, as well as in meeting its objective of being a consistent benchmark in it’s category. Changes in the index level reflect changes in the market capitalization of the constituents of the index.

When a stock is replaced by another stock in the index, the index is adjusted to ensure that change in index market value that results from the addition and deletion of a stock does not change the index level. Rebalancing Frequency: The index value are calculated real-time on all days that the National Stock Exchange of India is open, but their composition is rebalanced on quarterly basis.

Advantages of Index fund

Consistency

Index funds have the advantage of being low-risk investments in equities and bonds that are geared for steady, long-term growth. They are naturally diversified, covering a wide range of industries inside an index, which protects against large losses. Index funds also outperform the majority of non-index funds that try to outperform the market.

In 2011, U.S. News & World Report said that index funds related to the Standard & Poor’s 500 index outperformed nearly two-thirds of large-cap actively managed mutual funds during the previous three years. Various reports claim that less than 15% of the actively managed large cap funds in India have been able to beat the Sensex/Nifty indexes on a consistent basis over the last 3 to 5 years.

Low Fees

Compared to non-index funds, index funds have lower fees. Index funds have lower portfolio turnover which results in lower brokerage and other transaction costs. This means that even if a non-index fund outperforms index funds, it must outperform them by a specific margin in order to earn returns that cover its expenses. The average difference between expense ratios of large cap Index Funds and large cap actively managed funds could be between 0.5% to 1% a year. Over a 30 year period, for someone investing ₹10,000 a month, could lose anywhere between ₹20 – ₹50 lakh in fees. Transaction costs for funds can add up quickly.

A stable portfolio

Investing in an Index Fund allows you to maintain a stable portfolio as there is no pressure to chase the best performing mutual fund on a year on year basis. Understanding that there will always be funds that will over perform or underperform the index in any given year is crucial as this helps you stay put in an Index Fund. Since you do not have the pressure to chase the best performing fund on a year on year basis, you will not incur capital gains tax or exit loads on your investments.

Over long term periods, investors who have stayed put in an Index Fund have generated better returns than those who try to chase the best performing funds on a year on year basis. Below is a table depicting the year on year performance of popular large cap stocks from 2010 to 2020;

What are Index Funds?
Year on year performance of large cap mutual funds compared to Sensex Index Fund from 2010 – 2020

The best funds for a year are highlighted in green, whereas the worst performer for the year is marked in red. It is evident that people who jump from one fund to another in search of the best performer would have to deal with exit loads and capital gain taxes and will be thoroughly disappointed over long periods.

Disadvantages of Index fund

Lack of Flexibility

Index funds have less flexibility than actively managed funds since they must stick to policies and methods that force them to aim to perform in lockstep with an index. Index fund investment decisions must be made within the parameters of the index it is tracking.Unlike managed funds, index funds do not have the ability to outperform the market. This means that investing in an index fund implies foregoing the chance of a large profit. 

No Down Side Protection

 During turbulent times, when the economy is not at potential, the index fund does not have the option to trim the underperformers as it has to allocate funds to different stocks according to predefined weights in the index. Investors in an index fund are exposed to falling markets and move along with the index in both directions.

Important factors to understand before investing in Index Funds

  • Risks and Returns

Although Index funds are passively managed, they are still equity oriented. Equity instruments come with their risk characteristics and are volatile in the short run. It is important that you assess your risk profile before investing in them to ensure suitability. One needs to understand that the index funds move with the market, on both sides. Furthermore, because index funds try to mirror the index’s performance, their returns are similar to the index’s return.

  • Expense Ratio

The expense ratio is a small percentage of the fund’s total assets that the fund house charges for fund management services. Since these funds are passively managed on the basis on predefined parameters, there is no fund manager or a team of analysts. As a result, fund management costs are reduced, resulting in a lower expense ratio .

  • Invest according to your Investment Plan

Invest in accordance with your Investment Strategy. Investors with at least a 7-year or longer investing horizon may consider index funds. These funds have short-term swings along with the stock market, but these changes average out over time. Returns of 10-12 percent can be expected if you invest for at least seven years. You can use these assets to align your long-term investing goals and stay invested for as long as you can.

  • Capital Gains Tax (CGT) :

When you redeem an index fund’s units, you generate capital gains, which are taxed. The tax rate is determined by the holding period, or the time you were invested in the fund.

  • The capital gains you receive over a one-year holding period are called short-term capital gains (STCG), and they are taxed at 15%.
  • Long Term Capital Gains are the capital gains gained over a period of more than one year (LTCG). The first ₹ 1 lakh of long-term capital gains is tax-free every financial year. Any LTCG in excess of this amount is taxed at a rate of 10%, with no indexation benefits.

Who should invest in an Index Fund

Because Index Funds follow a market index, their returns are quite close to those of the index. As a result, these funds are preferred by investors who want to maintain a stable portfolio and wish to invest in the equity markets without incurring too many costs. In an actively managed fund, the fund manager adjusts the portfolio’s composition based on his evaluation of the underlying securities’ potential performance. This increases the portfolio’s risk factor as very few fund managers have been able to consistently beat the index over long periods. Index Funds are suitable for investors who want to maintain a simple portfolio without having the anxiety of choosing the best performing fund of the coming year !!!

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