What Are Index Funds India : Definition, Advantages & Disadvantages More

Investing in the stock market, which was once an option but it is now gradually becoming a necessity because it gives an opportunity to investors to earn a higher return on investor’s investment. Most of the average investors do not have any knowledge of investing while many investment products may be confusing and complicated to understand. This is the problem with investment in stock. So, without any knowledge about the market, investors can make better returns by investing in index funds than actively managed funds.   

Today in this article we will cover the definition of the index funds, advantages, disadvantages, how index funds work, and many more. So, If you are looking to invest then this article might help you. Take a look!

Definition of Index Fund

An index fund is a type of mutual fund that imitates the portfolio of an index. It tracks the market index which is made up of stocks and bonds. The index fund invests in many different indices such as Sensex, nifty and other indices. Investors can not make investments directly in an index, but they will be able to invest through the index mutual fund or an ETF(Exchange- Traded Fund). 

Index funds are passively managed which means it just follows the market index and it does not have fund managers to make all the investment decisions like an actively managed fund. 

Advantages of Index Fund

Portfolio Diversification

Index funds provide an opportunity to reduce the risk of volatility. It allows investors to place their money in the whole stock market rather than putting all money in a single stock or sector. It keeps investor’s investments safer in case of If one stock or bond is performing badly, then it doesn’t harm the portfolio’s performance.   

Lower Cost

The key advantages of index funds are low cost. This advantage allows investors to invest in the stock market without spending much money. The index funds are passively managed, their expense ratio is much lower than actively managed funds. Managers are not spending their time and money researching bonds or stocks to purchase and sell for the portfolio so the cost of managing the funds is much lower than the other.

Good Returns

The index fund offers a better return over a longer time horizon. As we earlier said that index funds are passively managed, its growth can be quite good for long-term investment because the index funds are relatively inexpensive which bring returns equal to, but not greater than the market or sector they track. 

Easy to Understand

Index funds give the smartest and easiest way to invest and build wealth. It is easy to understand the investment aims of an index fund and even once the investor understands the target index and the securities the index fund will hold and they can be determined. Index funds are also easy to manage, and investors buy the index and let others manage it for the investors.

Low-Risk

Another advantage of index funds is relatively low-risk options for investing in bonds and stocks that are designed for long-term and consistent growth.

Also, they are suitable for low-risk investors. It allows investors to invest with less risk because most of the index includes hundreds or a dozens of stocks and other investments and portfolio Diversification makes you less likely to incur significant losses if something bad happens to one or two companies in the index. 

Disadvantages of Index Fund

Tracking Error

Before investing in the index fund make sure to go for the one that has the lowest tracking error because there could be a small difference in the returns of the mutual fund and the index fund. If an index fund does not track its benchmark index accurately so the return will be different than that of the benchmark. 

Lack of Flexibility

In index funds, the fund managers must have to strictly follow the policies and strategies that are essential for them to attempt to perform with an underlying index in lockstep. This disadvantage pushes away some investors from index funds. The fund managers enjoy less flexibility as compared to the other investment. Because they do not have much flexibility to trade in and out of the investment. In actively managed funds, fund managers can have the flexibility to find better options in good times or bad while in the index fund, fund managers can not invest in different stocks when the market is in a downturn.

Can’t Beat Market Returns

The passively managed funds such as index funds do not attempt to beat the market, they only aim to match the performance of the index. They provide you either equal returns to that of the market or lower than that of the market. If investors want that the returns would be higher than that of the market, investing in actively managed funds would be a better option. Even investors lose the opportunity to take the advantage of specific growth in order to build meaningful profits from investment by investing in the index funds.

Types of Index Funds

Below are several types of index funds, every investor should know about. 

Broad market: This type of fund invests in a large segment of the investment market that can have some of the smallest expense ratios. The asset sales are extremely low and they are highly tax-efficient. It offers the broadest market exposure to investors.

Market capitalization: Those investors who have a longer time horizon can get the benefits from a wide basket of small and mid-sized companies. 

International index funds: International index funds offer international exposure if investors want to add some outside exposure so this fund provides it. This fund is not tied to a specific geographic region. This provides an amazing way to obtain diversified and broad exposure to a large segment of foreign markets.  

Bond based index funds: The bond based index funds can help investors to manage a combination of short, intermediate, and long-term bond maturities. 

Earnings based: There are two types of indices based on earnings: growth indexes and value indexes. Growth indexes consist of businesses that are expected to grow earnings rapidly than the overall market. The value indexes are made up of stocks that are trading at a lower cost compared to the earnings of the company. 

How is an Index Fund different from an Active Managed Fund?

Index funds follow a particular index like Bombay Stock Exchange(BSE), National Stock exchange(NSE), etc. If investors invest in the index fund that follows NSE, the investors will be indirectly investing in 50 underlying stocks likewise, if the investment makes an investment in BSE then indirectly they invest in 30 stocks. In this fund, investors do not have the support of the fund manager but in the actively managed fund, fund managers support the investors by choosing the best bonds, stocks, or other securities. 

Index fund reduces the costs such as brokerage, etc. and in the absence of fund managers, the expense ratio and the fund management charges are very low comparatively than actively managed funds. The actively managed fund tries to beat the market but the index fund matches the performance of a particular market benchmark(index).

Mostly the actively managed funds can be traded on Net Asset Value that gets revealed at the end of the day. The index funds are traded on the stock exchange so the investors can purchase or sell the funds at any point of time.

How does an Index Fund work?

The functions of the index fund are different from the actively managed fund. An index fund tracks the indices which they follow. The actively managed fund beats the benchmark on the other hand, passively managed funds like index fund objectives are to match or track the performance of the index. In the index fund, the fund managers decide which stock is to purchase and sell in accordance with the underlying index. Index funds will become very cheaper and have a low expenses ratio because of the quite simple nature of the operation. It is profitable for those investors who do not have that much knowledge of investing in stock and time to research well to find a good. Index funds make sure to invest in all the securities that the index tracks.

The Indian stock market has the two most popular and important indices the first one is Sensex and the second one is nifty. Sensex is the index of Bombay Stock Exchange(BSE) which is a group of 30 best-performing companies on the Bombay Stock Exchange. On the other hand, nifty is an index for the National Stock Exchange(NSE). It has 50 companies that’s why it is known as nifty 50. It includes the shares of the different sectors, so if an index fund is tracking the nifty 50 index, then this fund will have 50 stocks in its portfolio in a similar proportion.

How to invest in an Index Fund?

An index fund comes in two formats- one is an ETF(Exchange Traded Funds) and the other one is a normal index fund. Let’s take some examples of Exchange Traded Funds: Reliance Sensex ETF, HDFC Nifty 50 ETF, HDFC Sensex ETF.  If investors want to invest in an ETF then they need to open an account in Demat account. There are top banks to offer Demat Accounts in India. After creating a demat account, investors can buy this ETF. If we talk about normal index funds, the examples of normal index funds are SBI Nifty Index Fund, ICICI Prudential Nifty Index Fund, and HDFC Index Fund Nifty 50, etc. 

Normally the investment done in mutual funds is the same as the investment done in a normal index fund. In an ETF index fund, SIP stands for Systematic Investment Plan can not be done. A Systematic investment Plan means investors can invest fixed amounts monthly or quarterly or as per investor’s comfort via SIP. In the case of a normal index fund, a Systematic Investment Plan can be done. 

When it comes to choosing the index fund, always remember that it must have low-tracking errors, it must suit your risk profile and it must have a low expense ratio. Investors can invest in index funds directly without any distributor, whenever you buy the plan then ensure to get a direct plan the reason behind it is the expense ratio of the direct plan is very low. In the direct plan, you may need a financial adviser but they did not pay any commissions to the distributors. It has the potential to maximize the return as there is no commission paid. 

Who should invest in an Index Fund?

Index funds track a market index and give the returns that match the underlying index. If investors seek higher returns then actively managed funds are a better option. For the investors who prefer lower risk and expect predictable return then the index fund is an ideal option for them. If the investors seek market-beating returns then the investors can opt for actively managed funds. Moreover, index funds do not require extensive tracking. If investors wish to participate in equities but they are not ready to take the risks which are associated with an actively managed fund, they can choose a Sensex index fund or Nifty. The return of the index fund and the return of the actively managed fund may be matched in the short term but the actively managed fund performs better in a long run.

Top 5 Index Funds in India

Whenever you choose a fund firstly analyze the fund from different angles as it has various qualitative as well as quantitative parameters. Keep in mind your requirements, financial goals, risk profile, and investment horizon. So, here is the list representing the top five index funds in India based on the returns of the past three years. 

• Motilal Oswal NASDAQ 100 ETF
• ICICI Prudential NV20 ETF
• UTI Sensex ETF
• SBI ETF Nifty Next 50
• HDFC Sensex ETF

Wrap Up

So, if you are also planning for wealth creation and securing your future then you should think about investing in an index fund. As the index funds are affordable, less risky it is a great choice for most everyday investors. Index funds help to achieve long-term financial goals. But it totally depends on the investor’s financial objectives and their circumstances to decide the best type of funds.