Index Funds in India
It has been one of the hottest topics in the market, whether it’s high time to move to index funds in India.
Because the Nifty has been giving more returns in recent years. One of the major benefits of choosing index funds is, you can invest your funds passively in the global market.
Don’t you think this is a great opportunity to diversify your investment portfolio?
Before getting into full-length details about Index Funds, let us first understand how index funds are different from actively managed mutual funds
Index Funds vs. Mutual Funds
Most of the mutual funds charge a fee between 2% and 4%. It doesn’t matter how good the fund is working. They still charge you a fee even when they are losing your money. However, when it comes to good index funds, you are not charged much in terms of fees.
Additionally, mutual funds usually have higher fees compared to index funds. They both spread your funds across so many stocks. However, index mutual funds expand your portfolio more by tracking a specific index.
If you are someone who advises people to invest in mutual funds, you already know how mutual funds work. But, do you know how index funds work? How are index mutual funds better than active mutual funds? By the end of this article, you are going to understand everything about index funds.
What are Index Funds?
Index funds are one of the specialized types of mutual funds. They replicate a group of particular indices like Nifty (NSE 50 Index) and Sensex (BSE Sensitive Index), the two most popular ones in India.
Index funds build their portfolio by tracking standard market indices. Unlike actively-managed funds, index funds monitor index’s performance passively. Hence, they are also known as passive mutual funds.
Their main goal is to duplicate the index output, without surpassing the market. Index funds are cheaper than others because the fund house does not buy or sell shares for producing returns.
These types of funds usually catch investor’s eyes as they are invested in a broader market index such as the Nifty and the Sensex. In these indices, stocks find representation in their investment portfolio; also, ensure an identical performance of the tracking index.
How do Index Funds Work?
When Index Funds track a benchmark, for instance, the Nifty, its portfolio gets the fifty stocks that include Nifty, with the same proportions. The fund managers decide to buy and sell the stocks according to the benchmarks. Unlike active mutual funds, there is no research analyst team available for identifying opportunities and choosing stocks here.
Index fund’s main role is to match its index with its performance. Index mutual funds deliver returns almost equal to its benchmark. There may be a small difference between the index mutual fund and its target index which is called a tracking error. The fund manager has to bring down the tracking error as low as possible. The fund manager keeps stabilizing the percentage of the securities frequently to secure its position in the benchmark.
How to Choose Index Funds?
There are two major elements that you need to look into while choosing Index Funds – Tracking Error and Expense Ratio
1. Tracking Error
As already discussed, tracking error is the difference between the price of a portfolio and the price of a benchmark. It is also reported to be the percentage difference between the return on investment and the benchmark you are planning to imitate. A good index fund usually will have a lower tracking error.
2. Expense Ratio
Expense ratio is the amount businesses charge investors for managing a mutual fund or ETF (Exchange Traded Fund) or index fund. It usually represents the whole fees, including management and operation costs of the fund. Funds with lower expense ratio perform better.
Should You Invest in Index Funds?
Whether or not to invest in mutual funds purely depends on your investment goals and risk preferences. Index funds are ideal for you if you do not like taking risks, and you want predictable returns. For instance, if you are willing to take part in equities but do not like to take the risk with actively-managed equities, choosing Nifty or Sensex is a good option for you.
However, below is a list of 6 factors that you need to consider before deciding whether or not to invest in Index Funds in India.
Usually, the expense ratio of index funds is 0.5% or even less. Whereas, expense ratio, of actively-managed mutual funds, is between 1% to 2.5%. The fund managers do not need to come up with any investment strategy for index funds
If there are two index mutual funds tracking the Nifty, both of them will give similar returns. However, there will be a difference in expense ratio. Index funds with a lower expense ratio will give higher returns compared to the other one.
2. Investment Horizon
Index funds are usually more suitable for those who are planning to invest on a long-term basis. The funds may experience too many fluctuations during a short-term. The average suggested period to experience returns ranging from 10-12% in index funds, is at least for seven years in India. You need to keep patience that long to experience the full potential.
3. Return on Investment (ROI)
Beating the benchmark is not the goal of the index funds. They want to duplicate the performance of its index. Index funds track the benchmark passively unlike actively-managed mutual funds. Therefore, it is highly suggested to choose the funds with the lowest tracking error while investing in index mutual funds. The lower the errors are, the better the performance is.
4. Financial Goals
Index funds are an ideal choice for you if you are planning for long-term financial goals like retirement plans, or higher education of your child. They are perfect for generating potential wealth for you, which can help you even in retiring a little early.
Index funds do not need extensive tracking. They map an index. So, they are predictable and risk-free. So, it is clear that investing in index mutual funds is a great choice if you are planning to gain high returns. However, you may need to move to actively-managed mutual funds whenever there is a slump in the market because they lose their value in such times. That is why some experts advise investors to have a mix of both types: actively-managed and passively managed funds.
6. Tax Benefits
Whenever you redeem your index funds units, you can earn taxable capital gains. However, the tax returns depend on the holding period of your index funds. But, how are mutual funds taxed in India?
Capital gains made with a holding period of up to one year are known as STCG, Short-Term Capital Gains. Its tax rate is 15%. On the other hand, capital gains with more than one year are called LTCG, Long-Term Capital Gain. The tax rate is 10% for LTCG over 1 lakh, without the benefit of indexation.
List of Index Funds in India
Following is the list of 5 different types of index funds available in India.
1. Broad Market
Big market index mutual funds usually have the lowest expense ratio. Asset selling in the broad market is small but extremely tax-efficient. This type of index fund is suitable for those who want to have a mix of a variety of bonds or shares.
2. Global Index Funds
Also known as international index funds, these index funds offer international exposure. You can buy the Index funds, which will monitor the indices that are not related to any specific geographical location in the mutual funds market.
3. Market Capitalization
If you are someone who has long-time investment plans, you can take advantage of better exposure to the wide range of medium and small-sized businesses. Index mutual funds can help you achieve this based on market capitalization.
4. Bond Based
These types of index funds help you in maintaining a great combination of long, intermediate, and short term bond maturities that can generate steady revenues.
5. Earnings Based
Do you know index funds can work depending on the earnings or profits made by the company? They are broadly two types – value indices and growth indices. Value indices include stocks trading at a lesser cost than the company’s earnings. Growth Indices, on the other hand, include businesses that can generate quick profits in the market.
Best Index Funds in India
Following is the list of some of the best performing index funds in India, taken based on their past returns.
- Reliance Index Fund – Sensex Plan
- Reliance Index Fund – Nifty Plan
- ICICI Prudential Nifty Index Fund
- LIC MF Index Fund Nifty
- LIC MF Index Fund Sensex
- IDBI Nifty Index Fund
- SBI Nifty Index Fund
- Franklin India Index Fund Nifty Plan
- UTI Nifty Index Fund
How to Buy Index Funds in India?
Buying index funds in India is similar to other mutual funds. Here is the list.
- Online: with the AMC, third-party portals, trading account, or Demat account.
- Offline: with the AMC, or through distributors
However, there are a few things that you need to take into account before investing in any index fund. A per the regulation from SEBI, all the mutual funds need to be labelled on the following parameters:
- Nature of the Scheme: they need to mention the goal of the scheme, whether to provide a regular income or to create wealth to the investor in a given investment horizon (short term/intermediate/long-term).
- Objective: it should have a brief about the objective of the investment in a sentence followed by the type of the fund being invested in (debt or equity).
- Level of risk: low, moderately low, moderate, moderately high, or high.
So, make sure to read through the labeling before investing in any index funds.
The recent investment market makes it clear that the index funds have been shaping into the future. A massive amount of money is going into the top companies through index funds in India. Awareness also has been increasing among people. Gradually, you should move 20 to 25 per cent of your portfolio towards index mutual funds. However, make sure to build a perfect mix of index funds that qualify your risk profile.