As per SEBI, Index funds are open-ended schemes that track or mirror the market’s index. Of its total assets, an index fund has to make a minimum investment of 95% in securities that are included in the selected index. Today, index funds are an investment avenue for investors who are looking for a long-term and moderately risky investment option.
IDBI Principal was the first AMC in India to launch an index mutual fund tracking Nifty. The scheme was later converted to Principal Nifty 100 Equal-Weight fund. While index funds started off poorly in the global markets and Indian markets, they have evolved over the years and a lot of these are known to generate substantially high returns in the long run. Here, we will discuss the history of index funds and also throw light on some of their key features.
What is an Index Fund?
Index Funds are a type of mutual fund scheme that constructs the portfolio using a market index as a reference. An index fund’s performance, therefore, depends on the performance of the chosen index. They invest in shares in a similar proportion as a particular index.
Index funds are called passively managed funds since they passively track the performance of an index. Unlike actively managed funds, these do not aim to outperform the market. The objective of index funds is to mimic or replicate the performance of an index.
How do index funds work?
Here are some important aspects to note about an Index fund:
What comprises an Index fund?
Index funds are primarily made up of stocks, which are part of a stock index. If an index fund is following the Nifty 50, then it will comprise the same stocks that the Nifty 50 tracks. Similarly, an index fund that tracks Sensex will invest in the exact 30 stocks, which are measured by the benchmark index. The composition or proportion of investment is also spread in the same way as the benchmark index.
How it measures performance against the benchmark?
The primary objective of any index funds is to replicate the composition and performance of the index it follows. While technically the returns generated by an index fund should be similar to those of the index it follows, this may not always be true because of a concept called ‘tracking error. We will discuss tracking error in the features section below.
Management style
Index funds follow a passive management style, as fund managers do not need to actively pick stocks to invest in. Fund managers only ensure to replicate the index performance and try to keep the tracking error to a minimum.
What returns can be expected from index funds?
Historical trends suggest that returns on index funds are higher than actively managed mutual funds. While these do not attempt to outperform the market, they do follow the theory that the market always wins. Returns are higher in the long run as compared to active mutual funds, which perform better in shorter time spans.
Key features of index funds
Here are some noteworthy features of index funds:
Low expense ratio
The index fund expense ratio is less as compared to any actively managed funds. Actively managed funds may charge an expense ratio of 1-2%. An index fund, on the other hand, could charge between 0.20% to 0.50%. While this cost difference may look to be small, but in the long run as the returns compound, it can be close to 15% of an investor’s net returns.
Tracking error
Index funds involve a certain amount of tracking error, which is the difference between the returns of the index fund and that of its benchmark index. Investors must watch out for the amount of tracking error and remember that the lower the tracking error, the higher chances of good fund performance.
Liquidity
Index funds are highly liquid investments, as investors can easily get in and out of the investment at any time. However, investors who are looking to make the most of index funds must remain invested in them for the long term.
Portfolio diversification
An index fund mostly comprises stocks of top companies from the market-cap point of view. This is because the benchmark index often has stocks of leading market players spread across all sectors. The auto diversification concept of an index fund reduces the concentration risk for an investor, as it does not focus on a particular stock or a specific sector.
Choice of stocks
The choice of stocks in an index fund is not at the discretion of the fund manager. This reduces the scope of losses caused by inefficiencies in asset allocation. It also minimises any negative impact arising out of poor management.
Best Index Funds in India
Some top-performing index funds in India are listed below:
HDFC Index Nifty 50
| Fund Name | Benchmark Index | Minimum SIP Amt | Fund Manager | 5-Year Annualised Returns |
| HDFC Index Nifty 50 | Nifty 50 | Rs. 500 | Krishan Kumar Daga Arun Agarwal | 17.81% |
UTI Nifty Index Fund
| Fund Name | Benchmark Index | Minimum SIP Amt | Fund Manager | 5-Year Annualised Returns |
| UTI Nifty Index Fund | Nifty 50 | Rs. 500 | Kaushik Basu Sharwan Goyal Kamal Gada | 17.88% |
ICICI Prudential Nifty Next 50 Index Fund
| Fund Name | Benchmark Index | Minimum SIP Amt | Fund Manager | 5-Year Annualised Returns |
| ICICI Prudential Nifty Next 50 Index Fund | Nifty Next 50 | Rs. 100 | Kayzad Eghlim | 15.88% |
Motilal Oswal Nifty Next 50 Index Fund
| Fund Name | Benchmark Index | Minimum SIP Amt | Fund Manager | 5-Year Annualised Returns |
| Motilal Oswal Nifty Next 50 Index Fund | Nifty Next 50 | Rs. 500 | Swapnil Mayekar | 19.54% |
HDFC Index Sensex
| Fund Name | Benchmark Index | Minimum SIP Amt | Fund Manager | 5-Year Annualised Returns |
| HDFC Index Sensex | Nifty Next 50 | Rs. 500 | Krishan Daga Arun Agarwal | 18.63% |
Who can invest in index funds?
For investors who are considering an investment in index funds, here are some important points that can help them in making the decision:
- An investor should invest in an index fund depending upon his/her risk preference and investment objectives.
- These are ideal for risk-averse investors who mostly expect returns with the least amount of expenses.
- Index funds do not require close tracking since the asset allocation is automatic and follows the index.
- These funds can generate returns that are parallel to the upside swings in the chosen index.
- Investors who are looking for market-beating returns must invest in actively managed funds. This is because index funds do not aim to outperform the market.
End Note
Passive investment forms are the way forward for investors who are looking for low-cost investment options. While there is always a scope of losing out on higher returns from actively managed funds, the success of index funds depends on the volatility they experience and, in turn, the choice of the index.
Frequently Asked Questions
What is the average rate of return on index funds?
Some top-performing index funds in India have generated 5 year annualized returns of 15-18%.
What is the return on index funds?
Returns from the index funds generally depends on the following factors:
Index chosen
Tracking error percentage
Expense ratio
Which is the best index fund in India?
The top-performing index funds in India follow the Nifty 50 and Sensex. Some top-performing funds as per 5-year annualised returns are:
HDFC Index Nifty 50
UTI Nifty Index Fund
ICICI Prudential Nifty Next 50 Index Fund
Motilal Oswal Nifty Next 50 Index Fund
HDFC Index Sensex
Can you lose all your money in an index fund?
An investor has to carefully consider all aspects before investing in an index fund since these are subject to market volatility and have higher chances of downward swing in the short run. Index funds are known to fetch good returns in the long run.
Is now a good time to buy index funds?
Stock market performances are unpredictable in the short run and therefore, if an investor wishes to make an investment in index funds, he/she must invest now and remain invested for a long duration.
