What Are Index Funds? How Do They Work?

Index Fund is a type of mutual fund, that is also known as index-tied or index-tracked mutual fund. The fund is built in a way that its portfolio will match that of an existing market index like Nifty 50 or Sensex. The choice of index is not restricted to equity, it could be bond market instruments as well.

An index (benchmark index) in a securities market is a measurement of the changes in a certain category of the market. It is a statistical measurement used to make comparisons or understand the state of that section of the market in general. For example, Nifty 50 (commonly known as Nifty) is National Stock Exchange's main benchmark that gives the weighted average of 50 stocks from the 12 sectors of companies listed on the exchange. NSE also has other sector-based indices like NIFTY Bank, NIFTY IT, NIFTY Pharma, NIFTY Financial Services, etc.

BSE's Sensex and NSE's Nifty 50 are the two most popular indices of Indian stock markets comprising of major Blue chip stocks.

How do Index Funds work?

The index fund will replicate the index it is tracking. For example, if it is linked to Nifty 50, the fund manager will buy all the 50 stocks listed on Nifty 50 in the same proportion and weight as Nifty. As mentioned before, this index could be that of a bond market too.

The composition of the index fund will be maintained by buying and selling stocks as that of the underlying index. Returns from this index will be more or less the same as the benchmark, but sometimes due to tracking errors, the results could differ.

Difference between index funds and actively managed funds

Mutual fund houses have a team of research analysts that study and analyze investment opportunities based on which they choose instruments to bet money on. The basis to compare their performance is how they manage to beat the benchmark or another fund house in terms of the extent of returns made from investors' money.

Index funds are however not actively managed by analysts as the aim is just to match the results of the index it is tracking. Additionally, the expenses incurred on these funds are lower than those actively managed due to the passive involvement of analysts. The SEBI has however changed the mutual fund rules on Total Expense Ratio calculations after re-categorization, making the difference in the charges for actively managed funds and those passively managed smaller.

Things to consider before investing in index funds

• Both passive and actively managed funds are exposed to market volatility. Either way, there are uncertainties involved in the extent of returns you make.
• If you are a risk-averse investor and wish to invest in equity via mutual funds, index funds are a good option as these do not need to be tracked very often to see if you fund manager is giving you sufficient returns. The returns will depend on the rise or fall of the index.
• Experts suggest that actively managed funds yield better returns in a developing market like India that has the potential to grow.
• Actively managed funds tend to perform better in the short term while index funds are ideal for longer periods.
• You can consider to diversifying your investments in both to balance risk.
• If the mutual fund category chosen comprises mainly of the stocks in the index that you plan on investing, you can look at the expense ratio charged by the fund house as the returns could be more or less the same and the charges could make all the difference.

How are Index Funds Taxed in India?

Any profit or loss made from mutual funds are considered as capital gains/loss for taxation purposes.

If you hold on to the investment for less than a year, it will be treated as a short-term capital gain or loss. Tax is charged at the rate of 15 percent on STCG.

If you hold the investment for longer than one-year, any gains in excess of Rs one lakh will be taxed at 10 percent (starting financial year 2018-19) on long-term capital gains.