There are various types of mutual funds available in the market. One of the specialized types of mutual funds is called an index fund. These funds replicate the portfolio of a particular index such as the BSE Sensitive index (Sensex), NSE 50 index (Nifty), etc which are the most popular indices in India.
Index funds invest in securities in the same weightage comprising an index. The increase or decrease in the NAV is in accordance with the rise or fall in the index. However, it does not mirror the index exactly by the same percentage due to some factors known as “tracking error”.
Index funds, unlike actively managed funds, passively monitor a specific index's performance. The purpose of these resources is not to surpass the market. The only goal is to imitate the index output.
Since the portfolio of index funds are not actively managed, as the fund house does not buy and sell shares to produce returns, the index funds are relatively cheaper than other schemes.
Benefits of index funds
Index funds are becoming one of the most popular investment avenues. Due to its passive nature, a lot of new investors prefer index funds. Here are the benefits of investing in an index fund:
Globally, it has been observed that it becomes difficult for fund managers to beat their benchmarks as markets become more effective. In such markets, passive funds such as index funds are becoming the preferred investment vehicle. Index funds are hugely popular in India. They have a substantial presence in the large-cap room.
Index funds are also appealing due to their lower cost. The expense ratios for active funds are very high when compared to index funds.
The funds have an automatic clean-up of the portfolios. The indices used removed any asset which is underperforming. As an investor, you don’t have to worry if you have invested in a slow-performing asset; the index will do that job for you.
Index funds do not need any active management. Since the investors need not be concerned about the performance of certain funds, they can focus their attention to revaluating their portfolios periodically.
There is no security-specific risk as the investment is made in a basket of assets. A single share cannot cause major damage to the indices used.
Types of Index Funds
There are a variety of index funds. Here is what you need to know:
- Broad market: A big market index seeks to capture a wide range of the market. Large market index funds have typically the smallest expenditure ratios. Asset sales in broad index funds are really small and highly tax-efficient. A broad market index fund is suited for investors who want to get a basket with a variety of shares or bonds.
- International index funds: Global index funds provide you an international exposure. As an investor, you can purchase funds that monitor indexes that are not linked to a particular geographic region in emerging markets or frontier markets.
- Market capitalization: Investors who have a long-time investment horizon can benefit from increased exposure to a wide basket of small and medium-sized enterprises. Index funds can achieve this objective based on market capitalization.
- Bond based index funds: The use of bond index funds can help you to maintain a healthy combination of short, intermediate, and long-term bond maturities which generate steady revenues.
- Earnings based: Index funds can also work on the basis of the profits or earnings of a company. There are two types of indices linked to companies: growth indexes and value indexes. Growth indexes are made up of businesses that are expected to generate profits quicker than the others in the market. Value indexes consist of stocks that are trading at a lower cost compared to the earnings of the company.
How do index funds work
Since index funds monitor a specific index, they are passively managed funds. The fund manager chooses which stocks should be purchased and sold in accordance with the underlying index that the fund is following. There is a separate analysis undertaken to identify and select stocks for investments, unlike actively managed funds.
If an index fund monitors a benchmark such as the Nifty, its portfolio will have the same proportions of the 1000 stocks that make up Nifty. If two index funds are tracking the same underlying index, they will offer the same returns. However, the fund that has a lower expense ratio will generate relatively greater yields on investment.
The job of an active fund is to meet its benchmark. However, the function of an index fund is to match its efficiency to its index performance. Index funds typically yield returns that are more or less equivalent to the benchmark. There may be a tiny distinction between the results of the fund and the index which is called a tracking error. The fund manager ensures that the tracking error is reduced as much as possible.
Index funds are the perfect option for someone who wants to invest in equities but does not want to track their performances. Index funds offer returns that are linked to the performance of a particular index. Index funds also work for investors who have a long-term investment horizon.
Having said that, it is important to note that index funds yields may, in the short term, match the yields of actively managed funds. However, in the long run, the actively managed fund continues to perform better.
How to invest in index funds
In case you’re looking to invest in a mutual fund, you can do so in two ways: directly or through an agent. In the case of direct, you can invest either online or offline. However, in case you’re going through an investor, ensure that they are registered with the Association of Mutual Funds in India and have a AMFI Registration Number.
Investors can also invest in index funds directly without a distributor. For investments through the direct plan, the investor needs a financial adviser but does not have to pay any commissions to the distributors. This maximizes the returns as there is no commission paid.
Investors also have the option to invest directly with the mutual fund either by visiting the mutual fund branch or online through mutual fund website. Forms can be deposited with mutual funds through the agents and distributors who provide such services.
Before making an investment, the investor should take into account the track record of the index fund. As per SEBI regulations, all the mutual funds are required to label their schemes on the following parameters:
a) Nature of scheme – whether the aim is to create wealth or provide regular income in an indicative time horizon (short/ medium/ long term).
b) A brief about the investment objective (in a single line sentence) followed by kind of product in which investor is investing (equity/debt).
c) Level of risk depicted by a pictorial meter as under:
- Low - principal at low risk
- Moderately Low - principal at moderately low risk
- Moderate - principal at moderate risk
- Moderately High - principal at moderately high risk
- High - principal at high risk
An investor should take into account the product labeling before investing in index funds.
FAQs
I came across the term load in the offer document for index funds. What does it mean?
Load refers to the charge collected by a mutual fund when the units are sold. There are two types of loads: entry load and exit load. Entry load is levied when the investor buys a unit whereas exit load applied when the units are sold by the investor. At present, SEBI has mandated that no entry load can be charged by any mutual fund scheme. The exit load charged is credited to the scheme.
No scheme is allowed to increase the exit load beyond the level mentioned in the offer document. Any change in the load will be only for future investments and not to investments made earlier. If fresh loads are applicable or increased, the mutual funds are required to amend their offer documents so that the new investors are aware of loads at the time of investments.
The investors should take the loads into consideration while making the investment as these affect their returns.
What is an application supported by blocked amounts?
ASBA is a facility provided by banks to investors in new fund offers (NFOs) of mutual funds. If you apply for an NFO via ASBA, the application amount gets blocked in your bank account. While the amount stays in your account, it cannot be used until you are allotted the unit of a mutual fund.
Do any index funds provide guaranteed returns?
There are no guaranteed returns for index funds investments. As an index fund simply tracks the performance of an index like Nifty or Sensex, it always remains subject to market volatility. It is important to read the offer document thoroughly to understand the risks of a mutual fund scheme.
What is the expense ratio of a mutual fund?
The expense ratio refers to the annual fund operating expenses of a scheme, which is expressed as a percentage of the fund’s daily net assets. Operating expenses of a scheme include the administration, management, advertising related expenses, etc. If the expense ratio of a mutual fund is 1 percent per annum, it means that each year 1 percent of the fund’s total assets will be used to cover expenses. Information on expense ratios that may be applicable to a scheme is mentioned in the offer document.
As per the present regulations, there is no limit on any particular type of allowed expense as long as the total expense ratio is within the prescribed limits by SEBI.
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