What are Index Mutual Funds, Types and Advantages?

People are becoming more financially conscious and have started investing in various mutual funds. One such fund that is becoming hugely popular among investors is index funds. The fund is focused on matching the market index and providing market exposure while driving more profits. If you are also planning to invest in index funds, here’s everything that you should know!

What are Index Funds?

Are you wondering what an index fund is? A mutual fund that tracks the performance of an index is known as an index investing fund. Depending on the source, this kind of mutual fund is also known as index-tied or index-tracker funds. If you want to mimic the performance of a stock market index like the S&P BSE Sensex or the NSE Nifty 50, an index fund is your best bet. 

Many investors also believe in the passive investment strategy that seeks to replicate the benchmark index returns. So, the investors who know what Index Investing is, know that this investing offers great diversification and lowers expenses and fees immensely. 

In other words, the holdings of index funds meaning would mirror those of the underlying index it tracks. Due to this, the returns of index funds are identical to those of the underlying index. Since index funds are not actively managed, they offer a low fee structure. 

Investors in these funds aren’t looking to beat the market; instead, they’re tracking an index. Investors may use them to manage and balance the risk in their portfolios more effectively.

To replicate the Nifty 50, broad-based index funds must own those 50 stocks at the same weightings as the Nifty itself. A market sector index is classified as securities that represent that sector. These investments might be in the bond market or the stock market. India’s most popular stock market indices are the BSE Sensex and the NSE Nifty. 

One of the most common questions witnessed across the web is what is a low-cost index fund? Low-cost index funds are in high demand lately and are known as passive fund management since it follows a particular index, likely the top-performing stocks and bonds. Based on the composition of the fundamental benchmark, the fund’s management decides which firms to purchase and sell. Research analysts aren’t employed by an index fund, unlike those employed by actively-managed funds.

It is important to extensively know index funds before choosing the category of these funds you think will outperform their benchmarks. There is, however, a tracking error, which is the difference in performance between the fund and the index. The fund managers must make every effort to minimize tracking errors.

How do Index Funds Work?

A form of a passive fund, Index funds follow the benchmark index such as Nasdaq 100 and more. So when you put money in index funds, all the cash is distributed to the companies that make a particular index. Index funds also help diversify your portfolio, which is an added bonus.

In simpler terms, the goal of an index fund is to mirror the index it is following. This also makes index funds less volatile.

Key Takeaways

• A mutual fund that tracks the performance of an index is known as an index fund. Other names for these mutual funds are index-tied or index-tracked mutual funds.
• The index funds are offered with a low fee structure; they are not managed actively. Instead of outperforming the market, these funds follow certain preset rules so that funds can track a group of direct investments.
• The fund’s performance may differ from that of the index.
• As a rule, the assets held by an index fund are those of well-known companies unaffected by market fluctuations.

Who Should Invest in Index Funds?

A mutual fund investment depends on your financial goals and tolerance for market risks. An actively managed investment fund is when the fund’s money is invested by a manager or management team. In contrast, a passively managed fund merely tracks a market index. It lacks a management team capable of making investment choices. Investors looking for a steady income stream can consider index funds. 

These funds don’t need constant monitoring. To avoid the associated risks with highly volatile equity funds, consider investing in an index fund such as the Sensex or the Nifty. If the index rises, so will the value of these funds. Therefore, the risk involved in index funds is minimal compared to equity funds, which allows an investor to follow the same direction as the market’s sentiments.

These products may be of interest to long-term investors with a seven-year investment horizon. These investments are ideal for people with a higher capacity to take risks due to market fluctuations and volatility uncertainties.

Factors to Consider Before Investing

Here are some of the factors you need to consider before investing in the index funds-

Risks and Returns

Considering the index funds tracks the market, they are less volatile and perform well even if the market is fluctuating.

Index funds are among the safest equity funds because of their holdings in blue-chip companies. These investments represent companies having a solid track record. Thus, index funds provide comprehensive stability in the market because of their lower volatility. The benchmark indices of India, including S&P, Sensex, Nifty, and BSE, fared impeccably over the last three decades.

Several issues confronted them then, such as the 2008 recession, the emergence of several illnesses (such as Zika, Ebola, and H1N1), and global geopolitical tensions. Despite these challenges, the indices have seen substantial growth since their initial phase.

Expense Ratio

The key advantage of index funds is their lower expense ratio compared to their counterparts. The expense ratio, also known as the management expense ratio, includes various expenses such as transaction fees, advisors and managers fees, and accounting fees.

Taxation Rules of Index Funds

Index funds are also subjected to tax rules as they fall under the equity funds category. You will have to pay the Dividend Distribution Tax and Capital Gains Tax.

Dividend Distribution Tax

In dividend distribution tax, when the fund house pays dividends, the TDS of 10% will be deducted.

Capital Gains Tax

Whereas for capital gains tax, when you redeem the units of your index funds, you will gain taxable capital gains. For short-term capital gains, you will have to pay 15%, whereas, for long-term capital gains, you will have to pay 10% when the amount exceeds Rs. 1 Lakh.

Advantages of Index Mutual Funds

Here are the major advantages of index mutual funds-

1. Lower expense costs
2. Diverse market and portfolio exposure
3. The index funds are easier to manage as they follow the benchmark market index
4. There are numerous tax benefits that you will receive

Conclusion

Going through the entire guide would have helped you know what index funds are.  The only reason index funds mean lower fees is that they are predictable assets allocated and managed passively. Moreover, the low cost-to-income ratio is achieved by limiting the frequency of trading assets. An index fund’s investments often consist of well-known companies unaffected by short-term volatility in the market. 

If this is true, index funds manifest that investors are at low risk of losing the full amount invested. Investors willing to take on some personal risk in exchange for modest returns might consider investing in an index fund.

FAQs

Also read about NAV in Mutual Funds on Investment Simplified.