What are Index Funds? Learn their Investment Benefits, Taxation, Limitations & Common Misconceptions

Index funds are passive mutual funds designed to replicate popular market indices. Instead of actively selecting stocks and industries, the fund manager invests in all the stocks within the index. The fund’s stock weight closely matches each stock’s weight, ensuring the portfolio stays in sync with the index.

When a stock’s weight in the index changes, the fund manager adjusts the portfolio by buying or selling that stock to maintain alignment. While passive management simplifies the process, the fund’s returns may differ from the index due to tracking errors.

Tracking errors arise because maintaining the exact proportions of securities can be challenging, and transaction costs are incurred. Despite this, index funds are ideal for investors seeking broad market exposure without the risks of individual stock selection. This article will delve deep into what index are, their features, taxation, limitations and more!

What are Index Funds in India?

Index Funds are mutual funds that track a specific stock market index, such as the S&P 500. Thus, the method of investing in an index fund is called index fund investing.

Index investing aims to replicate the underlying index’s returns rather than try to outperform it, which means the investor holds the same stocks in the same proportion as the index. This contrasts with actively managed funds, where a fund manager picks and chooses individual stocks to include in the fund.

These funds are constructed by purchasing all the stocks in the tracking index, which means they’re more passive than actively managed funds. This also means they have lower operating costs since there’s no need to pay a fund manager to make investment decisions.

Best Index Fund in India (2024)

Here are the best-performing index mutual funds based on their 5-year CAGR:

Name	AUM (in Cr)	Expense Ratio	1Y Returns	5Y CAGR
UTI Nifty Next 50 Index Fund	₹3,833.32	0.34%	66.14%	22.17%
DSP NIFTY Next 50 Index Fund	₹613.85	0.30%	66.15%	21.91%
ICICI Pru Nifty Next 50 Index Fund	₹4,909.40	0.30%	66.12%	21.90%
LIC MF Nifty Next 50 Index Fund	₹84.08	0.32%	65.68%	21.88%
Sundaram Nifty 100 Equal Weight Fund	₹79.07	0.57%	48.61%	19.90%
DSP Nifty 50 Equal Weight Index Fund	₹1,408.53	0.40%	37.37%	19.41%
Bandhan Nifty 50 Index Fund	₹1,219.39	0.10%	26.41%	15.95%
UTI Nifty 50 Index Fund	₹16,924.52	0.18%	15.15%	15.76%
ICICI Pru Nifty 50 Index Fund	₹8,941.14	0.17%	26.29%	15.75%
Tata NIFTY 50 Index Fund	₹717.24	0.20%	26.22%	15.71%

Disclaimer: Please note that the above list is for educational purposes only, and is not recommendatory. Please do your own research or consult your financial advisor before investing.

Note: The data on the list is from 14th May, 2024. This data is derived from the Tickertape Mutual Funds Screener.

🚀 Pro Tip: You can use Tickertape’s Mutual Fund Screener to research and evaluate funds with over 50+ pre-loaded filters and parameters.

Overview of the Top 10 Index Funds

UTI Nifty Next 50 Index Fund

The UTI Nifty Next 50 Index Fund – Regular Plan has a current Net Asset Value (NAV) of Rs. 25.55 for its Growth option. Its trailing index funds returns are 65.78% over 1 year, and its 3-yr CAGR is 23.35%. The fund manages assets worth Rs. 3,833.32 cr. with an expense ratio of 0.34%. There is no exit load. The minimum investment is Rs 5000, with additional investments starting at Rs. 1000, and the minimum Systematic Investment Plan (SIP) investment is Rs 500.

DSP NIFTY Next 50 Index Fund

DSP Nifty Next 50 Index Fund – Regular Plan has a current NAV of Rs 27.70 for its Growth option. The fund’s returns are 65.77% over 1 year and its 3-yr CAGR is 23.46%. The fund manages assets worth Rs 613.85 crore with an expense ratio of 0.30%. There is no exit load for this fund. Investors can start with a minimum investment of Rs 100, with additional investments and SIPs also starting at Rs 100.

ICICI Pru Nifty Next 50 Index Fund

ICICI Prudential Nifty Next 50 Index Fund’s current NAV is Rs 63.21 for the Growth option of its Regular plan. Its 1-yr returns are 67.00% and 3-yr CAGR is 23.33%. The fund’s assets under management (AUM) stand at Rs 4,909.40 cr. It has an expense ratio of 0.30% and does not charge an exit load. The minimum investment required is Rs 100, with additional investments and SIP starting at the same amount.

LIC MF Nifty Next 50 Index Fund

LIC MF Nifty Next 50 Index Fund’s current net asset value (NAV) for the Growth option of its Regular plan stands at Rs 53.31. Its 1-yr returns are 66.55%, and 3-yr CAGR is 23.37%. The fund manages assets under management (AUM) worth Rs 84.08 cr and maintains an expense ratio of 0.32%. There is no exit load applicable to this fund. Investors can start with a minimum investment of Rs 5000 and add a minimum of Rs 500 subsequently. The Minimum SIP (Systematic Investment Plan) investment amount is Rs 1000.

Sundaram Nifty 100 Equal Weight Fund

Sundaram Nifty 100 Equal Weight Fund’s current net asset value stands at Rs 172.74 for the Growth option of its Regular plan. Its returns over one year are 48.51%, and its 3-yr CAGR is 20.03%. The fund’s assets under management total Rs 79.07 cr. It has an expense ratio of 0.57% and does not impose any exit load. The minimum investments required are Rs 100, with the same amount applicable for additional and SIP investments.

DSP Nifty 50 Equal Weight Index Fund

DSP Nifty 50 Equal Weight Index Fund – Regular Plan’s current net asset value is Rs 23.97 for its Growth option. Its 1-year returns are 36.76% and its 3-yr CAGR is 19.83% . The fund holds assets under management totalling Rs 1,408.53 crore. It features an expense ratio of 0.40% and does not impose an exit load. The minimum investments required are Rs 100, with the same amount applicable for additional investments and SIPs.

Bandhan Nifty 50 Index Fund

Bandhan Nifty 50 Index Fund – Regular Plan’s current net asset value (NAV) for its Growth option is Rs 50.22. The fund’s returns over one year are 27.03%, and its 3-yr CAGR is 15.41%. The fund holds assets under management (AUM) totalling Rs 1,219.39 crore. Its expense ratio is 0.10%, and no exit load is applicable. The minimum initial investment and subsequent additions are Rs 1000, while the minimum SIP investment is Rs 100.

UTI Nifty 50 Index Fund

UTI Nifty 50 Index Fund – Regular Plan’s current net asset value (NAV) is Rs 159.52 for its Growth option. Its returns over 1 year are 26.97%, and its 3-yr CAGR is 15.16%. The fund’s assets under management (AUM) stand at Rs 16,924.52 crore, with an expense ratio of 0.18% and no exit load. The minimum investments required are Rs 5000, with Rs 1000 for additional investments and Rs 500 for SIP investments.

ICICI Pru Nifty 50 Index Fund

ICICI Prudential Nifty 50 Index Fund’s current net asset value (NAV) is Rs 233.84 for the Growth option of its Regular plan. It has 1-year returns of 26.91% and 3-yr CAGR of 15.29%. The fund’s assets under management (AUM) total Rs 8,941.14 crore. Its expense ratio is 0.17%, with no exit load applicable. The minimum investment required is Rs 100, and the minimum SIP investment is Rs 100.

Tata NIFTY 50 Index Fund

Tata Nifty 50 Index Fund – Direct Plan currently has a net asset value (NAV) of Rs 156.56 for its Growth option. Its returns over one year are 26.84%, and its 3-yr CAGR is 15.29%. The fund holds Assets under Management (AUM) totalling Rs 717.24 crore. It has an expense ratio of 0.20% and imposes an Exit Load of 0.25% if redeemed within 7 days. The minimum investment amounts will initially be Rs 5000 and Rs 1000 for additional investments. The minimum SIP (Systematic Investment Plan) investment is Rs 150.

What are the Types of Index Funds? 

• Broad Market Index Funds: Broad market index funds aim to replicate the performance of large market indices like the S&P 500. These funds offer diversified exposure to various sectors by holding a portfolio that mirrors the index’s composition. Managed passively, they don’t involve active stock selection or market timing.
• Market Capitalisation Index Funds: Market capitalisation index funds weigh their holdings based on the market cap of the companies in the index. Larger companies have more weight, reflecting their greater value. These funds offer exposure to market performance proportional to the size of constituent companies.
• Equal Weight Index Funds: Equal weight index funds give the same weight to each stock in the index, regardless of market cap. This approach provides balanced exposure, offering more representation to smaller companies and potentially capturing more growth opportunities.
• Factor-based or Smart Beta Index Funds: Factor-based index funds, or smart beta funds, track indices built on specific investment factors like value, growth, or low volatility. They allocate weights based on these factors, deviating from traditional market cap weighting. Examples include the iShares Russell 1000 Value ETF, the Invesco S&P 500 Low Volatility ETF, and the Vanguard Small-Cap Value Index Fund.
• Strategy Index Funds: Strategy index funds focus on specific investment themes or sectors, such as technology or renewable energy. These funds align with particular market trends, providing targeted exposure without picking individual stocks.
• Sector-Based Index Funds: Sector-based index funds concentrate on specific industries, offering exposure to sectors like technology or healthcare. They diversify within the sector, reducing the risk of investing in individual stocks while allowing for a more focused investment approach.
• International Index Funds: International index funds invest in markets outside the investor’s home country, tracking indices of global stocks, bonds, or other securities. These funds provide geographical diversification and access to international growth opportunities.
• Debt Index Funds: Debt index funds, or bond index funds, aim to replicate the performance of specific fixed-income indices. They invest in various government and corporate bonds, providing diversified exposure to the fixed-income market. Examples include Vanguard Target Retirement Funds, Fidelity Freedom Funds, and BlackRock LifePath Index Funds.
• Custom Index Funds: Custom index funds are tailored to meet specific investment goals of large institutional investors or clients. These funds can be customised to include or exclude certain sectors or adhere to ESG standards, reflecting the investor’s preferences and beliefs.

How are Returns Calculated in Index Funds?

Understanding the future value of your investments is crucial for making informed decisions. An online index fund calculator can estimate the growth of your index fund investments over time by using the formula:

FV = P × ((1 + r)n – 1) / r) × (1 + r)

Here:

FV = Future value of the investment

P = Individual investment via a systematic investment plan (SIP)

r = Expected rate of return from the index fund

n = Number of SIP instalments

The table below illustrates potential returns for different investment amounts, rates of return, and investment periods:

Monthly SIP Amount (Rs.)	Expected Rate of Return	Investment Period	Maturity Value (Rs.)
5,000	12%	8 years	8.08 lakh
10,000	14%	10 years	26.21 lakh
15,000	10.5%	12 years	43.34 lakh
3,000	11%	15 years	13.77 lakh
6,000	14%	18 years	58.52 lakh

How to Invest in Index Funds in India?

Here is how one might invest in index funds:

1. Open an investment account with a brokerage firm or a financial advisor. Most online brokers offer commission-free trading for index funds, making it easy and affordable for investors to get started. 
2. Next, enter the ticker symbol or name of the index fund you want to invest in and the amount you want to invest. 
3. Finally, review your order and click “submit.” 

Note: Investors must consult a financial advisor and conduct thorough research before investing in an index fund.

How are Index Funds Different From ETFs?

Aspects of Comparison	ETFs	Index funds
Requirement of DEMAT Account	Requires a DEMAT account	No DEMAT account is required
SIP Investment	Cannot invest through SIPs	Can invest through SIPs
Expense Ratio	Lower expense ratios	Higher expense ratios
Fund Management	Provides flexible trading options	Managed primarily by fund managers
Valuation of Funds	Valued continuously	Valued at the end of the day

Benefits of Investing in Index Funds in India

• Low Expense Ratios and Cost Efficiency: Index funds follow a passive management approach, where fund managers replicate a particular index instead of picking individual stocks. This strategy reduces costs, resulting in lower expense ratios and making these funds affordable for investors.
• Broad Market Exposure and Diversification: Investing in index funds offers diversification benefits. These funds replicate a stock index, investing in various stocks that comprise the index. This broad exposure spreads risk across multiple companies, sectors, and industries.
• Consistent Performance and Long-Term Growth: Index funds are designed to mirror the performance of an underlying index that has shown consistent growth over time. Unlike individual stocks, which are unpredictable, index funds allow investors to benefit securely from the overall market’s upward trend.
• Minimising Individual Stock Risk with Index Funds: Diversification is key in investments. Relying on a single stock can be risky if the company’s performance falters. In contrast, index funds invest in various stocks within an index, reducing the impact of any company’s poor performance on the overall fund.
• Tax Efficiency and Capital Gains Benefits: Index funds have low turnover due to their passive management, resulting in fewer trades and fewer capital gains distributed to investors. Most index funds adopt a buy-and-hold strategy, enhancing their tax efficiency.

Limitations of Investing in Index Funds in India

Now that we have discussed the advantages, let’s have a look at the limitations below:

• Lack of Alpha: Index funds passively track benchmark indices, aiming to match their performance, not beat them. This means they won’t outperform the market and may miss out on opportunities for higher returns.
• Limited Control: You don’t have any control over the individual stocks held in the fund, as the underlying index dictates the composition. This can be less appealing to investors who prefer actively managing their portfolio selections.
• Tracking Error: Although index funds aim to mimic the index, they may experience slight deviations in performance due to factors like tracking methodology, expense ratios, and cash drag. Cash drag refers to the delay between when an ETF receives a dividend and when it uses the proceeds.
• Downside Exposure: During market downturns, index funds can experience losses just like the underlying index. This can be risky for investors seeking downside protection or capital preservation during volatile periods.

Taxation on Index Funds

Index funds are liable to Dividend Distribution Tax (DDT) and capital gains index fund taxation, as are equity funds.

Equity Index Funds

• Short Term (Less than 1 year): Profits from selling within a year are considered Short Term Capital Gain (STCG) and taxed at 15%
• Long Term (More than 1 year): Holding for more than three years categorises the profit as Long-Term Capital Gain (LTCG), taxed at 20%, with indexation benefits

Debt Index Funds

• Short-term (Less than 3 years): Selling within three years adds the profit to your taxable income, which is taxed at your regular rate.
• Long-Term (More than 3 years): Holding for more than three years categorises the profit as Long-Term Capital Gain (LTCG), taxed at 20%, with indexation benefits.

How Do Index Funds Work?

They track an index’s returns by investing in exactly the same stocks and with exactly the same weightage. For example, if the Nifty-50 has Infosys with a 6% weightage, the index fund that tracks the Nifty-50 will also have Infosys as 6% of its portfolio. This way, these generate returns almost identical to the index’s.

This fund aims to provide returns consistent with the benchmark index they’re tracking. This means that if the index goes up, the value of the index fund should also go up, and if the index goes down, the fund’s value should also go down. Although index funds aim to mimic the index, they may experience slight deviations in performance due to factors like tracking methodology, expense ratios, and cash drag.

Index Funds India may not require a team of researchers and portfolio managers to monitor the market constantly, allowing them to reduce costs significantly. As such, they can be cheaper than most mutual funds—the difference being as low as 0.10% total expense ratio for certain passive funds and TERs of 1.50-2.25% for many active mutual funds.

What are the Costs Associated with Index Funds? 

Index funds are known for their cost-effectiveness due to their passive management strategy. The main costs associated with index funds are typically expense ratios which is typically lower the expense ratio in than actively managed funds. Expense ratios cover the fund’s operational and management expenses. Since index funds aim to replicate the performance of a specific broad market index, they require less active management, resulting in lower operating costs. Additionally, investors might face minimal transaction costs as index funds have lower portfolio turnover.

Common Misconceptions About Index Funds

There are several misconceptions about index funds. Let’s examine these misconceptions and why they are false.

• Not Diverse Enough: Index funds are designed to expose investors to a broad range of stocks or bonds, making them highly diversified. For example, the Bandhan Nifty 50 Index Fund invests in large and mid-cap stocks.
• Not Actively Managed: While index funds do not rely on active management to select individual stocks or bonds, they still require careful management to track the index accurately. Fund managers must rebalance the portfolio periodically to maintain its alignment with the underlying index.
• Not as Profitable as Actively Managed Funds: While some actively managed funds may outperform index funds in the short term, numerous studies have shown that index funds tend to outperform actively managed funds over the long term. They typically have lower fees, which can significantly impact an investor’s returns.

Factors to Consider Before Investing in Index Funds in India

Before investing in index mutual funds, let’s explore these key factors:

• Risk Involved: Index mutual funds are generally less risky due to their passive nature and lower volatility than actively managed funds. However, tracking error is an important aspect of monitoring. A lower tracking error indicates lower risk. It’s also wise to diversify by including active funds like equities, as poor market performance can impact index funds.
• Cost Efficiency: Index funds are inexpensive because they don’t require active management. Without the need for a fund manager or complex strategies, these funds offer higher returns at lower costs.
• Tax Implications: Index mutual funds are subject to two types of taxes: Capital Gain Taxes (CGT) and Dividend Distribution Taxes (DDT).

a. Capital Gain Taxes

• Short Term Capital Gain Tax (STCG) of 15% applies if the holding period is up to one year.
• Long Term Capital Gain Tax (LTCG) applies if the holding period is more than one year:
• No tax for LTCG up to Rs. 1,00,000.
• A flat 10% tax for LTCG over Rs. 1,00,000.

b. Dividend Distribution Tax (DDT)

• If your annual taxable income exceeds Rs. 5,00,000, a 30% tax is deducted from the dividend.
• Low Flexibility: Index funds mimic indices and are managed passively, limiting fund managers’ ability to buy or sell securities based on market conditions. This means they can’t easily adjust to the poor performance of individual companies within the fund.

To Wrap It Up…

Investing in index funds is an excellent way for investors to gain exposure to a diversified portfolio of stocks or bonds at a low cost. By following the steps outlined in this blog, interested investors can explore index funds and how to invest in them. However, conducting thorough research and conducting a financial advisor before investing is essential. 

Frequently Asked Questions About Index Funds

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