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Your essential guide to investment in Index Funds

  • Akshatha Sajumon
  • Feb 18 2021
  • 11 minutes
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Index funds are a subcategory of mutual funds that invest a collected corpus of funds in the index. For instance, an index fund that is benchmarked to NSE Nifty will buy stocks in the index and these will be in the same proportion as the index itself. The idea is to replicate returns generated by the Index that it aims to follow. Index fund investment is also known as a passive investment since investors do not have to pick stocks actively. 

Despite the simplicity of Index funds as investment avenues, most Indian investors are not aware of it. The few who are aware of this category of investment prefer actively managed funds because they are risk-averse and assume that Index funds may carry higher risk.

If you are new to Index funds and would like to explore this investment type, we have put together a guide for the same. Read on to find out how you can start with Index fund investments. 

What are Index Funds?

Definition of Index Funds

In simple terms, an Index fund is a kind of mutual fund which builds its portfolio using the same composition as that of a market index like Sensex or NSE Nifty. The fund invests in stocks that are part of the benchmark index selected and replicate the composition as well.

Let’s consider an example to better understand this concept. If HDFC Bank and Reliance Industries Limited make up 5% and 2% respectively of Nifty 50, then the index fund, which uses Nifty 50 as a benchmark, will allocate the same percentages of the portfolio to the said stocks. 


 

How do index funds work?

One unique characteristic of an Index fund is that it is not actively managed by a fund manager. Since the portfolio mirrors an index’s composition at all times, there is no necessity for a fund manager to intervene with stock selection. This results in the Index fund’s NAV moving in the same direction as the index which it follows. 

Why do people invest in index funds?

Most Index fund investors get attracted to the diversification that it offers in an investment portfolio. Since Index funds replicate the composition of indices, there is also the attractive return factor that draws people towards them. 

While the Indian market still sees a very limited amount of investment in Index funds, these are slowly but surely gaining popularity as more and more investors get educated about this investment avenue.

How to Invest in Index Funds?

Investing in Index funds is similar to the process of mutual fund investment. This can be done either directly or through an agent/distributor. To avoid the hassle of physically visiting the mutual fund office, it is best to choose an online distributor for investment. Here is how you can go about it:

  1. Choose an Index fund for your investment (details on how to choose an ideal index fund’ can be found in the next segment)
  2. Select an online distributor through which you can make the investment. This will offer convenience as you will not require a Demat account or physical visit to the fund’s office.
  3. Go through the list of fund options available and make the investment after following KYC procedure listed out by the online distributor.

How to choose an ideal index fund

While choosing an ideal index fund, investors must consider two key factors:

  1. Lower expense ratio – An ideal index fund is one that aims to generate returns that are very close to the benchmark index’s returns. If there is a higher expense ratio associated with an index fund, the returns could be far lower than the benchmark, and it is nearly impossible to generate higher returns than the benchmark. Hence, the lower the expense ratio, the higher the chances that it will generate similar returns as the benchmark index.
  2. Lower tracking error – Variance between Index fund returns and the percentage gain/loss of the Index it follows is called tracking error. For instance, if an Index fund has gained returns of 4% and the Index has gained 4.5% then the 0.5% difference is known as tracking error. Since the primary aim of any index fund is to keep returns closer to the index, investors must look for a fund that has lesser tracking error. This means, the fund manager is constantly tracking the index and leaves very little scope of error, which would otherwise result in lower returns than the index.

How to invest in Index Funds through Finity?

It is now easy to invest in Index funds with a few clicks using the Finity app on your mobile phone. Follow the below-mentioned steps to expand your portfolio with an ideal Index fund option through Finity:

  1. Install and launch the ‘Finity’ app using your smartphone
  2. Click on the ‘Equity’ option within Top Mutual Funds
  3. Scroll down to find ‘Index funds’ as an available option and click on it
  4. The screen will now show various time horizons for investment. Depending on your requirement, you can select any of the time horizons to start.
  5. The app will show you funds as per the time horizon selected, and there are ratings against each fund to make the selection easier. Click on the ‘Invest’ option in the fund of your choice.
  6. Choose between ‘Monthly SIP’ or ‘One-Time Lump Sum’
  7. Enter the amount you wish to invest and ‘Proceed’ 
  8. Enter your PAN number to enable the app to check your ‘investment readiness’
  9. The app will then ask you to fill in basic details along with KYC information
  10. The last step is to enter bank account details and make a payment towards your investment

Top index funds to invest 

India-Specific Index Funds

HDFC Index Nifty 50 – Launched back in 2012, this equity mutual fund scheme has a minimum SIP investment requirement of Rs. 500. Historical 1-year returns of the fund are 24.56%.

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 – This scheme was started in 2013 and historical 1-year returns are  25.04%. 

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 – This scheme is an open-ended index scheme that aims to invest in securities that are part of Nifty Next 50 Index. has 1-year historical returns of 19%. 

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 – This is an open-ended scheme that replicates/tracks Nifty Next 50 Index. The scheme was started in 2019 and historical 1-year returns of this scheme are estimated to be around 19%.

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 – With historical 1-year returns of about 25%, this fund is also one of the top-performing index funds in India. It was launched in 2012. The fund is preferred for its low expense ratio 0.1%.  

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%

 

International focussed Index funds

Motilal Oswal S&P 500 Index Fund – This open-ended index fund has a historical 6-month return of approx 13%. The 6-month time horizon is mainly since it is a relatively new scheme. The suggested investment time horizon for this scheme is 5 years and above. This fund is benchmarked and invests in the S&P 500 index on New York Stock Exchange.

Fund Name Benchmark Index Minimum SIP Amt Fund Manager
Motilal Oswal S&P 500 Index Fund S&P 500 Index Rs. 500 Abhiroop Mukherjee

Herin Visaria

 

Motilal Oswal Nasdaq 100 Fund Of Fund – This is an open ended scheme with historical 1-year returns of nearly 47%. It is one of the preferred investment schemes in the index funds category. Started back in 2018, the scheme follows the NASDAQ 100 Index as a benchmark index.

Fund Name Benchmark Index Minimum SIP Amt Fund Manager
Motilal Oswal Nasdaq 100 Fund Of Fund NASDAQ 100 Index Rs. 500 Ashish Agrawal

Abhiroop Mukherjee

 

Edelweiss MSCI India Domestic & World Healthcare 45 Index Fund – This index fund scheme was launched in Nov 2020 and has generated annualised returns of about 11% since inception. Following the MSCI India Domestic and World Healthcare 45 Index, it primarily invests in stocks of 45 healthcare sector companies that are listed in India and the USA.

Fund Name Benchmark Index Minimum SIP Amt Fund Manager
Edelweiss MSCI India Domestic & World Healthcare 45 Index Fund MSCI India Domestic and World Healthcare 45 Index Rs. 500 Hardik Varma

Amit Vora

Advantages of Investing in Index Funds

Index funds offer many advantages, especially to new and risk-averse investors. Some of the major advantages are as listed below:

  • Lower Expense Ratio: One of the main advantages of Index funds is a lower expense ratio, which is primarily because the funds are not actively managed. The expense ratio comprises the cost related to fund operations and management fees. Investors can benefit from an expense ratio of 0.5% in Index funds against a 1-2.5% ratio in actively managed funds. For instance, one of the top-rated Index funds in India ‘ICICI Prudential Nifty Next 50 Index Fund’ has an expense ratio of 0.39%, far lower than most actively managed mutual funds.
  • Disciplined Approach: Index funds adopt a very disciplined approach towards the selection of stocks and their proportions, as compared to fund managers randomly timing the market.
  • Cost savings: Investors also save on brokerage costs, since the investment is based on the chosen index.
  • Tax efficiency: Index funds can be tax-efficient apart from having comparatively lower expense ratios. The tax save mainly comes that there is no need to switch between funds depending on performance.
  • Ideal for the risk-averse: It is an ideal investment choice for investors who are risk-averse but still want a certain level of equity exposure along with portfolio diversification benefits.

Things to be Careful About

Every investment form comes with some set of disadvantages. Here are some of the major drawbacks of Index funds that are important for investors to consider before making an investment:

  • Miss out on investing in Small & Mid caps: Index funds are focused on large-cap stocks and therefore have a lesser advantage as compared to actively managed funds which can have small and medium cap focus. Index funds may prove less beneficial for aggressive investors who are looking at a 7-10-year horizon. 
  • Possible investment in non-performing stocks: Index funds sometimes lay heavy dependency on high-performing stocks. The composition of an Index fund keeps changing as per the Index itself. Thus, a stock will carry heavy weightage in the fund if it weighs heavy in the Index. This will be true even if the stock is overvalued. This percentage composition cannot be modified since the fund is not actively managed. For instance, if Nifty 50 has a 5% contribution of Reliance Industries Limited stocks, the Index fund following Nifty 50 will mirror this contribution irrespective of the expected stock performance of RIL.

End Note

Index funds can be used to begin an investment journey, as it is a form of passive investment. Some investors also use it for portfolio diversification and better returns by following a benchmark index. It is up to an investor to make the most of this investment opportunity and generate strong returns through the benchmark index’s performance during upward trends.


Frequently Asked Questions

Are Index Funds good for short-term investments?
Index fund investments must be made for at least 5 years to see good returns. In the short-run, these could fluctuate as per changes in the indexes that they follow. 

Can I invest in Index funds if I am a beginner?
Many investors who are beginners prefer to invest in index funds since they offer exposure to a wide variety of stocks. There is also the benefit of diversification and comparatively lower risk involved.

How do I invest in Index funds?
You can invest in Index funds by using the Finity app. It is easy to download and user-friendly. Through the app, you can pick an Index fund of your choice by comparing the available metrics. After completing the basic KYC process, you can start investing in an Index fund of your choice.

What is the minimum investment amount in an Index Fund?
The minimum amount to be invested in an Index fund differs as per the conditions laid by the fund. In most domestic funds, however, the minimum SIP investment is around Rs. 500.

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