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 Nifty 50. 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 (2025)
Here are the best-performing index mutual funds based on their 5-year CAGR:
| Name | AUM (Rs. in Cr) | Expense Ratio (%) | Absolute Returns 1Y (%) | CAGR 5Y (%) |
|---|---|---|---|---|
| Motilal Oswal Nifty Smallcap 250 Index Fund | 845.04 | 0.36 | 26.78 | 29.80 |
| Motilal Oswal Nifty Midcap 150 Index Fund | 1,986.47 | 0.3 | 24.10 | 28.07 |
| UTI Nifty Next 50 Index Fund | 4,872.88 | 0.36 | 28.23 | 19.74 |
| DSP NIFTY Next 50 Index Fund | 902.86 | 0.28 | 27.91 | 19.56 |
| LIC MF Nifty Next 50 Index Fund | 96.87 | 0.32 | 28.02 | 19.54 |
| Motilal Oswal Nifty Next 50 Index Fund | 310.18 | 0.35 | 28.23 | 19.53 |
| ICICI Pru Nifty Next 50 Index Fund | 7,010.42 | 0.31 | 27.86 | 19.50 |
| DSP Nifty 50 Equal Weight Index Fund | 1,895.15 | 0.38 | 10.50 | 19.36 |
| Sundaram Nifty 100 Equal Weight Fund | 97.27 | 0.57 | 16.98 | 18.63 |
| Motilal Oswal Nifty 500 Index Fund | 2,060.24 | 0.2 | 15.95 | 18.47 |
Disclaimer: Please note that the above table is for educational purposes only, and is not recommendatory. Please do your own research or consult your financial advisor before investing. The data is derived from Tickertape Stock Screener and is subject to real-time updates.
Note: The data on the list is from 2nd January 2025. This data is derived from the Tickertape Mutual Funds Screener using the following filters:
- Plan: Growth
- Category: Index Funds
- CAGR 5Y: Sorted from Highest to Lowest
🚀 Pro Tip: You can use Tickertape’s Mutual Fund Screener to research and evaluate funds with over 50+ pre-loaded filters and parameters.
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 Nifty 50. 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?
You can easily invest in index mutual funds by following these steps:
- To invest in mutual funds, you can visit an equity investment platform such as smallcase or Tickertape.
- The next step would be to research and identify the best index funds to invest in which aligns with your investment thesis. You can easily select and learn more about the best index funds with the help of a financial tool like the Tickertape Mutual Fund Screener. With 50+ pre-loaded filters, it helps you to create a comprehensive list by giving insights about the fund’s performance. Try it now!
- Once you have selected the funds based on different metrics and parameters, go to smallcase.com or the smallcase app, and login via your phone number. Click on ‘Discover‘ and enter the name of the specific mutual fund name in the search bar and hit enter. You can click on ‘invest now’ and select whether you want to invest a lump sum amount or start a SIP and start investing!
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 as per Union Budget 2024-25
Index funds are taxed as equity funds in India and understanding the latest tax regulations on equity mutual funds is essential for making informed investment decisions. The Union Budget 2024 has introduced significant changes to the taxation of equity mutual funds, simplifying the tax structure while altering rates and benefits. Here is a detailed breakdown of the new tax rules:
Short-Term Capital Gains (STCG)
If you hold equity mutual funds for less than a year, the gains from these investments are classified as short-term capital gains. According to the new budget, these gains are now taxed at a rate of 20%, which has been increased from the previous rate of 15%.
Long-Term Capital Gains (LTCG)
For equity mutual funds held for more than a year, the gains are considered long-term capital gains. The key points to note under the new budget are:
- Tax-Free Limit: Gains up to Rs. 1.25 lakh in a financial year remain tax-free. This limit has been increased from the previous threshold of Rs. 1 lakh.
- Tax Rate: Any gains above Rs. 1.25 lakh are taxed at a flat rate of 12.5%. It was previously taxed at 10%.
- Indexation: It’s important to note that the benefit of indexation, which previously allowed investors to adjust the purchase price of their assets for inflation, has been removed for all asset classes, including equity mutual funds.
Indexation is a method used to adjust the purchase price of an asset (like property or gold) for inflation over the years. This adjusted price is then used to calculate capital gains. Previously, long-term capital gains from selling property, gold, or other unlisted assets were taxed at 20%, but you could use indexation to reduce your taxable profit. The new rule simplifies the tax structure by setting a flat 12.5% tax rate for all long-term capital gains. However, it removes the indexation benefit.
Summary
| Capital Gains Tax | Holding Period | Old Rate | New Rate |
| Short-Term Capital Gains (STCG) | Less than 12 months | 15% | 20% |
| Long-Term Capital Gains (LTCG) | More than 12 months | 10% | 12.50% |
No Indexation Benefit: This change affects the overall tax liability, potentially increasing it for long-term investors.
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.
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 are typically lower than 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.
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
A good index fund accurately tracks a market index, has a low expense ratio, and minimal tracking error. It offers broad market exposure and stability and is aligned with an investor’s financial goals.
Here are some of the top 5 index funds in India based on their 5-year CAGR:
1. Motilal Oswal Nifty Smallcap 250 Index Fund
2. Motilal Oswal Nifty Midcap 150 Index Fund
3. UTI Nifty Next 50 Index Fund
4. DSP NIFTY Next 50 Index Fund
5. LIC MF Nifty Next 50 Index Fund
Note: The data on the list has been taken on 2nd January 2025.
Index funds can work well for SIPs because they provide low costs, broad diversification, and returns that mirror market performance. Systematic Investment Plans (SIPs) benefit from rupee cost averaging, which helps manage market volatility over time. This combination makes them a practical choice for disciplined, long-term investment strategies. However, investors should conduct market research and consult a financial advisor before investing.
Debt investments in index funds are rare. However, this can happen in funds based on hybrid indices that allocate both equity and debt.
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