Index funds take diversification to the next level by providing a broader market exposure within an asset class. We invest in various asset classes to build a diversified portfolio and minimize risk. But even within an asset class, there can be opportunities to diversify further.

For instance, in equity, you can diversify by investing in stocks from multiple industrial sectors or across market capitalizations. Index funds can be an ideal choice for this level of diversification. Check out this post to learn what is an index fund? How does it work?

What is an Index Fund?

An index fund is a specific category of mutual fund designed to replicate the performance of a particular market index. These funds follow a passive investment strategy, aiming to closely match the returns of indices. They achieve this objective by either holding all the securities within the index or a representative sample, offering investors access to broad market exposure, diversification benefits, and cost-effective investment options. To gain a deeper understanding of index investing and index funds, continue reading below.

How Do Index Funds Work?

Index funds operate by diligently tracking the performance of benchmark indices, such as NIFTY 50 or SENSEX. The fund manager initiates the process by first deciding the index and then planning for launching the fund. The index should be aligned with the fund’s objective. Subsequently, they acquire all or a representative selection of the securities that constitute the chosen index, maintaining proportional weight according to the index's composition. Tracking difference occur when the index undergoes rebalancing; the fund manager buys or sells securities as necessary to align with the updated index weights. This passive management approach effectively reduces operational costs compared to actively managed funds, resulting in lower expense ratios. Through index replication, the fund's portfolio mirrors the underlying index with the aim of generating comparable returns over time.

What are the Different Types of Index Mutual Funds?

To better understand index fund meaning, you should also know about the different types of index funds available in India. Some of the top options are-

• Broad Market Index Funds

  A broad market index fund replicates a larger market segment. For instance, there are index funds based on the Nifty 100 and Nifty 500 indices. These schemes allow investors to gain exposure to a broader range of stocks across sectors.

• Market Capitalization Index Funds

  These index funds invest in stocks across market capitalizations, like small-cap, mid-cap, and large-cap, to achieve diversification.

• Equal Weight Index Funds

  If we take the Nifty 50 index, for example, the 50 stocks that make the index have different weights. However, an equal weight Nifty 50 index fund will have the same 50 stocks as Nifty 50 but with the same weightage of 2% each.

• Sector-Based Index Funds

  Sector-based index funds invest in stocks of companies that belong to the same industrial sector. For instance, you can find index funds with Nifty Bank, Nifty PSU, Nifty Technology, and Nifty Healthcare as their underlying index.

• International Index Funds

  International index funds track foreign indexes such as S&P 500, Hang Sang, and NASDAQ. These funds are ideal for investors looking for exposure to the international markets.

What are the Benefits of Investing in Index Funds?

• Diversification

  With an index fund, you can gain exposure to a broader market segment and build a diversified investment portfolio.

• Lower Expense Ratio

  Unlike many other equity funds, index funds are passively managed and do not require the fund manager to make investment decisions constantly. This results in a lower expense ratio than other actively managed funds.

• No Human Bias

  As index funds imitate the underlying index, these schemes have no human bias or judgment errors.

Index Funds vs. Actively Managed Funds

Who should invest in an Index Fund?

Here are 5 key benefits of index funds that make them suitable for:

1. Passive Investors: Individuals who prefer a hands-off approach and seek broad market exposure without engaging in stock picking or market timing.

2. Cost-Conscious Investors: Those focused on minimizing investment costs, as index funds typically have low.

3. Tax-Sensitive Investors: Investors looking to minimize their tax liabilities, as index funds tend to have minimal turnover, resulting in greater tax efficiency.

4. Beginning Investors: Individuals who are new to investing and want an easy-to-understand and research-friendly option to start their investment journey.

5. Diversification Seekers: Those who seek instant diversification across a specific market segment, as index funds provide a straightforward means of achieving diversification objectives.

What Things Should You Consider Before Investing in Index Funds?

Here are some of the factors you should take into consideration before investing in an index fund-

1. Risk Appetite

   - Index funds can deliver negative returns if the underlying index underperforms. Thus, adding passive and active funds to your portfolio is advisable.
   
   Also Read - What are Passive Funds?

2. Investment Horizon

   Index funds are ideal for longer investment horizons of 5 years or above as short-term fluctuations can impact the returns.

3. Tracking Error

   While index funds try to imitate the underlying index and deliver similar returns, they have tracking errors that could impact their performance. Therefore, look for an index fund with a lower tracking error while selecting. •

How are Index Funds Taxed?

Index funds are treated as equity funds for tax purposes. IDCW (Income distribution cum capital withdrawal) from the schemes are added to the investor's taxable income and taxed as per their income tax slab.
Capital gains are taxed based on whether you’ve generated Short-Term Capital Gains (STCG) or Long-Term Capital Gains (LTCG).

• STCG in Index Funds

  As index funds are taxed as equity funds, you generate STCG if you redeem the units within 12 months of investment. These gains are taxed at 15% + cess + applicable surcharge.

• LTCG in Index Funds

  If you redeem the units after 12 months of investment, you’ll generate LTCG. These gains are taxed at 10% + cess + applicable surcharge. However, LTCG of up to Rs. 1 lakh* is not taxable in equity oriented funds like index funds.

*- The limit of Rs 1 lakh is inclusive of LTCG on equity shares and equity oriented mutual funds.

Building Long-Term Wealth with Index Funds

If you believe that the Indian markets could outperform in the future, index funds can be an excellent way to participate in the rally.

But as all mutual funds, including index funds, come with varying levels of risk, do your research and consult an investment advisor before investing.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.