Index Funds

What are Index Funds?

An index fund, as the name suggests, invests money in an index benchmark. In India, the role of the benchmark is fulfilled by Nifty, Sensex and likewise indices. The performance of an index fund is directly proportionate to the performance of these benchmarks. However, due to the direct proportionality, the fund management becomes rather passive than active.

As said earlier, index funds are funds directly dependent on the benchmark. Therefore, it is important to identify the appropriate benchmark. Recently indexing has been deemed extremely successful in surpassing other types of mutual funds. The reasons behind this are its connectivity with the performance of the benchmark, reduced dependency on research or study of different avenues, and low expense ratio.

However, index funds do not necessarily generate the same returns as their corresponding benchmarks. Some index funds may fail to match the performance of their benchmarks and result in a much lower value. This is caused due to a tracking error – an error that is the difference between the performance of the index and the performance of the fund. The fund managers, therefore, have a task at hand to reduce the tracking error as much as possible.

Should you invest in index funds?

For short-term investors, index funds tend to be useful. However, judging by the history of index funds in India, it is difficult to see past the actively managed funds. The performance of actively managed funds is more suited to the Indian economy. However, if predicting a certain market condition is possible such as a sudden growth in Sensex or Nifty, then index funds could be more profitable.

Types of Index Funds

Generally, there are no certain different types of index funds. Their evaluation is based on the following factors:

1. Index Fund Based on the Type of Index

As seen earlier, index funds are based on different indices. It can be either BSE Sensex, Nifty or any other indices. Depending upon the performances of these indices, the decision of investment differs.

2. Index Fund Based on Return

The index fund based on the different indices differs in their returns. For example, index fund investing in high yielding indices will generate higher returns. Therefore, indices performing consistently will provide better returns.

3. Index Fund Based on Type of Risk

The underlying indices of each index fund have a risk of their own. Therefore, from an investment perspective, to identify the index with lower risk and higher return shall be ideal. For example, Nifty 50 is a better index than BSE Sensex due to its higher volatility.

Benefits of Index Funds

1. Low Expenses

As discussed above the Index funds require a very low amount of expenditure to manage. Since the funds are based on indexes, the cost of managing these funds is cut down substantially.

2. Returns Nearly Matching Indices

All the actively managed funds try to match the return of the market. However, they often fail to achieve the same due to over-evaluation or under evaluation of the market. In index funds, the benchmark itself carries the fun, therefore, the question of matching it hardly arises, subject to tracking error.

3. Less Research

Other funds require constant research to help funds outperform or at least match the market returns. This eventually raises the cost of managing these funds and puts more pressure on the fund managers. Index fund allows the indices to do the talking and hence research becomes a bit secondary.

4. Low Pressure on Fund Managers

Talented fund managers who can sail the funds over the line are a rare breed in the market. Additionally, increasing work and market pressures make them even rarer. Index fund makes the job of fund managers relatively easy.

5. Diversification

Investing in index fund allows you get the benefit of diversification. In this way, even if one underperforms the other carries it.

List of top Index Funds

1. HDFC Index Fund – Direct (G) –Sensex Plan

One of the oldest index fund, launched in December 2012, having its basis on BSE Sensex. It gave a return of 18.49% in its first year and currently giving an average return of 12.98%.

2. UTI Nifty Fund – Direct

Once more an equity oriented fund launched in January 2013. This fund unlike above is moderately or reasonably risky, perhaps due to Nifty 50 may be, which gave a moderate return of 15.92% in its year of inception and since then giving an average return of 12.43%.

3. ICICI Prudential Nifty Next 50 – Index Fund

Born in January 2013, same as the UTI fund. However, unlike the UTI fund, this is a high-risk fund and provided an output of 8.89 % in its first year. Thereafter the fund has been on gradual upwards trajectory giving an average return of 17.79%.

4. HDFC Index Fund – Nifty Plan

Once again for risk-averse investors, this is a moderately risky fund launched in December 2012 which gave an initial return of 15.93% and thereafter continued to give return at an average of 15.44%.

5. SBI NIFTY Index Fund – Growth

Launched in the year 2002, it is one of the most popular index funds in the industry and has a moderately high risk. The fund has generated 13.93% of returns since its launch.

Detailed Analysis of the Types of Index Funds

As stated earlier there is no specific distinction in index funds. The differentiation varies on the basis of underlying indices, which according to their performances decide the growth of the fund. Now some of these indices may be highly risky such as the BSE Sensex. On the contrary, some of the funds might be moderately or relatively low risk if the underlying indices are government bonds or blue-chip companies. Which index fund is profitable or can be profitable depends upon the term of the investment. For instance, a high-risk index fund can fetch higher profit in short-term investment, however, it may require constant gazing; so when the right opportunity arises, one may immediately liquidate the investment. On the contrary, it may be possible that due to the high-risk nature, there might be a considerable loss as compared to other index funds.

Therefore, types of index fund vary based on the indices. The indices, which suits or caters the needs of investors differ and so do the returns of index funds. One should carefully study the trend of the indices. For instance, if the BSE Sensex is growing at a level higher than the other indices, it is worth giving the due respect to its high volatility. On the other hand, the Nifty 50 (shares of top 50 companies on NSE) can be moderately risky indices and may give a sustainable amount of return without fetching much risk and also give a solid diversification.

Performance of Index funds in India

If we look at the picture in India, the index funds have so far not been up to notch in beating the actively managed funds.

The question is why the index funds have performed so dully? The answer is over dependency on BSE Sensex and Nifty indices. The index funds have performed supremely well in the overseas market and that’s because of plenty of options such as ‘NASDAQ’ – which has high potential companies, the ‘US S&P 500 index’ – which has the corporate heavyweights and many more. Index funds are very static in nature due to their dependency on the indices, while actively managed funds can flex its muscles to achieve better returns. In a developing economy like India, economists believe that index funds will have their say slowly and steadily. However, the actively managed funds will continue to outperform the benchmarks on a consistent basis in the near future.

Different Ways to Invest in Index Funds

There are currently two ways to invest in index funds,

1. Open Ended Index Funds (‘OEIF’)

This is the same system as the mutual fund, where in accordance with NAV, the units can be bought and sold. The cost and returns can be lower as compared to the other way of investing in index funds i.e Exchange Traded Fund. The OEIF can be bought in a similar way to a SIP, by regularly investing and plus there is no need to open a separate Demat account. These funds are better for long-run stability and quick liquidity.

2. Exchange Traded Fund (‘ETF’)

This fund can be brought only with the help of a stockbroker and stock exchanges, thus need a Demat account. The ETFs offer better returns, however, they lack the system like SIP and can cost slightly higher due to their different values in each month. They also lack the feature of quick liquidity, as buying and selling might take some time and thus making it difficult to calculate the average returns.

Taxation of Index Funds

The liquidation of index funds attracts Capital Gain tax on each transaction subject to its profit or loss. The rate of tax differs as per the period of holding of such investment. If the holding period is less than 12 months it attracts higher tax in the form Short Term Capital Gain (STCG) while if the period is more than 12 months it attracts Long-term Capital gain (LTCG). STCG tax is higher than the LTCG tax. In current scenario after the budget of 2018, the LTCG is taxed at 10% if the capital gains rise above 1 lakh per year.