Index Funds: Pros and cons of investing in them

Index investing is a form of passive investing that involves buying and holding a portfolio of stocks that mirrors the constituents of a specific index with the aim to try and match the returns of that index, subject to tracking error. The fund manager of an index mutual fund creates a portfolio that has a proportionate representation of each security of the relevant index. Exchange Traded Funds or ETF investment also follow a similar passive approach and replicate the benchmark index.

This is unlike active mutual funds, where fund managers handpick stocks and try to potentially outperform the market.

In this article, we will provide an overview of index investing and its benefits and disadvantages for an investor.

• Table of contents

1. What are Index Funds
2. Pros and cons of index investing
3. Key features of index investing
4. Overview of major Indian stock market indices
5. Steps to start investing in index funds

What are index funds?

An Index Mutual Fund invests in stocks that replicate a stock market index such as the NSE Nifty or BSE Sensex. These funds are passively managed, meaning the fund manager invests in the same securities as those in the index, maintaining the same proportions without altering the portfolio composition. The goal of these funds is to deliver returns that closely match the performance of the index they follow.

Pros and Cons of index investing

Like any investment option, index funds come with their own set of advantages and drawbacks. Understanding the pros and cons can help investors decide whether index funds align with their financial goals and risk tolerance.

Key features of index investing

• Passive investment strategy: Index investing is a passive investment strategy that involves a “buy and hold” approach. The portfolio tracks the performance of a specific index.
• Diversification: Index investing can provide exposure to different sectors and industries. This can potentially help to mitigate the risk associated with investing in a single stock or sector.
• Relatively low cost: Passive index funds have relatively lower expense ratios compared to actively managed mutual funds. This is because index funds don’t require active management, as the portfolio is designed to track the index performance.
• Tax-efficient: Capital gains from equity-oriented index funds may receive favourable taxation depending on the holding period. Investments held for more than a year are subject to long-term capital gains tax of 10% (as opposed to 15% short-term capital gains tax for a holding period of less than a year).

Overview of major Indian stock market indices

• Nifty 50: The Nifty 50 is a benchmark index that represents the performance of 50 of the largest and most liquid companies listed on the National Stock Exchange. It covers a wide range of sectors and is widely used as a benchmark for investment performance.
• S&P BSE Sensex: The Sensex is a benchmark index that represents the performance of 30 of the largest and most liquid companies listed on the Bombay Stock Exchange. It is widely followed by investors and financial media as a gauge of the Indian stock market's performance.
• Nifty Next 50: The Nifty Next 50 is an index that represents the performance of the next 50 largest and most liquid companies listed on NSE, after the Nifty 50. It provides a broader representation of the Indian stock market and can be a useful tool for investors looking to diversify their portfolio beyond the large-cap space.
• Nifty Bank: The Nifty Bank index tracks the performance of the banking sector in India. It includes the largest and most liquid banking stocks listed on the NSE.
• BSE Midcap: This represents the performance of the mid-sized companies listed on the BSE.
• Nifty Smallcap: The NSE Smallcap indices represent the performance of the small companies (by market capitalisation) listed on the NSE.

Steps to start investing in index funds

Here are the steps to get started with investing in index funds:

1. Understand index funds: Learn about different indices and the funds that track them to choose one that aligns with your investment goals.
2. Set investment goals: Determine your financial objectives, risk tolerance, and investment horizon. Equity-oriented index funds can be suitable for long-term goals as they have the potential to build wealth over time but are vulnerable to volatilities, especially in the short term. To estimate the potential returns on your investment, you can use an SIP mutual fund calculator.
3. Choose the right fund: Compare various index funds based on their expense ratio, tracking error, and the underlying index they follow. Lower expense ratios and minimal tracking errors are desirable.
4. Start investing: Start with a lumpsum or set up a Systematic Investment Plan (SIP) for disciplined investing. You can invest directly through the asset management company, or through a distributor or aggregator platform.
5. Monitor: Periodically review your investments to ensure they align with your goals.

FAQs

What are index funds?

Index funds are pooled investment vehicles that aim to replicate the performance of a specific market index. They offer investors exposure to a diversified portfolio of stocks or other assets.

What is an investment index?

An investment index, also known as a market index, tracks the performance of specific assets like stocks or bonds, serving as a benchmark for market performance.

What is index investing?

Index investing is a passive strategy where investors aim to replicate the performance of market indices, such as the S&P BSE 500 or the Nifty 50, rather than selecting individual stocks to beat the broader market.

What are the benefits of index funds?

Index funds offer cost efficiency with low expense ratios due to passive management, making them affordable for investors. They provide broad market exposure by replicating indexes, ensuring diversification and reduced risk, while also delivering performance and long-term growth by mimicking well-performing indices. Additionally, their low turnover and buy-and-hold strategy enhance tax efficiency, making them a suitable choice for long-term investment.

Can I directly invest in index funds in India?

Yes, if you have a demat account you can directly invest in Index funds in India.

Are index funds better than mutual funds?

Index funds can be suitable for most investors seeking simplicity, cost-effectiveness, and low risk. However, actively managed mutual funds may be more suitable for those with specific goals or a higher risk appetite.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.