What are Index Funds: Meaning, Advantages & Risks

Index funds have long been described as one of the sharpest investment alternatives. Apart from being inexpensive and less risky, index funds make it possible to create diversification and generate high returns for investors given some period.

In this post, we are going to cover everything you need to know about index funds, like benefits, risks, and more:

What are Index Funds?

An index fund is a specialised mutual fund that buys the same stocks in a particular market index. These funds passively track a chosen index, like the NIFTY 50 or the Sensex, aiming to replicate its performance minus management fees. Unlike actively managed funds, where stock selection relies on individual judgment, index funds follow a predetermined rulebook, making them cost-effective and transparent.

Some key characteristics of index funds are:

Investments are spread across a basket of securities that seek to replicate the index
Holdings are systematically adjusted to match the weights of the index
There is minimal buying/selling as the fund just has to mirror the index
Expenses are low as there is no active stock picking required
Performance depends mainly on the underlying index

Who Should Invest in Index Funds?

The decision to invest in the mutual fund is primarily based upon factors such as risk preference and the respective financial goals of an investor. Based upon this, index funds are most suitable for naturally successful investors with predictable return expectations. One of the salient features of any index fund is you can track such funds sparingly. For instance, you can always choose a Sensex or Nifty index fund when investing in equities without taking much risk. These funds give you decent returns that match the upside of that particular index.

Advantages of index funds:

Index funds are one of the most straightforward and plain methods for building wealth. Index funds can benefit potential investors if, in the long run, the return on their investment is similar to that represented by the benchmark.

Here are some of the advantages of index funds:

Low Fees: One of the most critical benefits associated with index mutual funds is low fees. On the other hand, actively managed funds have high costs and give lower returns than the market. That's because an index fund manager must buy the stocks or other investments in an index without having you pay it.
No Investing Experience Required: Index funds do not require business knowledge or stock-picking; hence, they are ideal for whoever has money to save and invest.
Broad Range of Investment: Index funds span extensive investments. This ranges from stock and bond index funds, two reasonably common investment strategies. Apart from this is the ability to purchase other focused index funds that target particular financial market areas.
Saves Time: Investments in index funds will save you plenty of time. You will spend a few minutes up to a couple of hours in a year, depending on the type of index funds you settle on. This is because by utilising index funds, you limit the time the individual security research takes and can let the fund's portfolio manager invest in an index that has all the securities you would want to have been invested in.
Pay Less in Taxes: Index funds enjoy tax treatment that is generally more favourable than other investments. For instance, you receive no long-term capital gains due to a lack of purchases or sales of holdings.
Easy to Manage: Comparatively, index funds are much easier to manage because making efforts to track the vast number of stocks included in the index is not required. Instead, what may be needed from the fund managers is only occasionally rebalancing the portfolio.

Risks Associated with Index Funds

An index fund would be exposed to the same risks regarding the stocks and securities listed on its particular index. Moreover, the fund may also be exposed to a variety of other forms of risk:

As they are linked to an index, investors bear the systematic risk of the broader market segments the index covers.
The funds must refrain from deviating from the index by tactically underweighting or avoiding overvalued sectors when required. This can sometimes cause short periods of underperformance.
While costs are lower than active funds, expenses from tracking errors, rebalancing trades, etc, still apply, reducing net returns slightly.
Index funds in India may have higher tracking errors due to comparatively lower liquidity in some constituent stocks.
If the underlying index has concentration risk, for example, in a few major stocks, the index fund will perpetuate this. Diversification may still be limited.

How to Invest in Index Funds?

Here are some tips for investing in index funds:

Go with a broad market index fund tracking some major indexes like Nifty 50 or Sensex. It will give exposure to large, established companies from all sectors. Popular index mutual funds in India are the UTI Nifty Index Fund, HDFC Index Fund - Sensex Plan, ICICI Prudential Nifty Index Fund, etc.
Look out for index funds with a low expense ratio, preferably less than 1%. A lower expense ratio means more of your money gets invested rather than going towards administrative charges.
Invest through the Systematic Investment Plans (SIPs) periodically for the long term. The SIP allows you to invest a fixed monthly amount, which helps average the market's ups and downs. Invest for at least 5-7 years to see some good returns.
Allocate your core portfolio to index funds. You can allocate 60-80% of the equity portfolio towards the index funds and the remaining towards the actively managed fund for diversification.
Opt for Direct plans instead of Regular plans. In Direct plans, expense ratios are low as there is no distributor commission burden.
Go for ETFs (Exchange Traded Funds) if investing will be done under a demat account. Expense ratios, in the case of index mutual funds, are comparatively much lower.
Rebalance the portfolio occasionally to maintain the targeted asset allocation between equity and debt.
Avail a good broker for paperless investment into direct plans across fund houses.
If required, seek advice from a financial advisor on selecting appropriate index funds matching your goals and risk-taking capacity. Start small, but be regular.
Opt for a fund with a high AUM of at least ₹ 1000 cr since a low AUM can lead to tracking errors.
Measurement of the tracking error should always be regarding the difference between index and fund.

Which Index Mutual Funds in India Are Popular?

Some of the most common index funds tracking Indian market indices are:

Many fund houses offer index funds based on thematic indices and cover sectors, market caps, sustainability, etc. Investors have a decent range to choose from based on their specific needs.

Conclusion

For parking money in the stock market through a diversified and low-cost route, index funds have become a favoured option for most Indian investors. While they may trail actively managed funds in some years, index funds are designed to provide consistently market-like returns over the long term. They offer passive investors an accessible vehicle that provides broad exposure to markets with not much fuss with management. However, these funds pose a particular disadvantage, such as risks from the tracking error, costs, and concentrated indices. In conclusion, index funds have become a mainstay investment among many equity investors in India.