Why should you invest in Index Funds | Top Performing Index Funds
Have you ever faced inconstant returns from your equity mutual funds? I mean, a day NIFTY50 jumps by 3%, but your portfolio did not grow the same. Or, your fund faced a fall more than NIFTY50? Well, it is a common situation if your portfolio does not have any index mutual funds. If you are looking for an equity investment option that can earn as much as equity indicators (indices), you are probably in the right place.
Presently we are at a time when all debt instruments are fetching interest at the lowest level (maybe worst has not come yet), an index fund can be a wealth creation tool bearing minimum risk involved. But wait, are they safe like debt instruments? Honestly, the answer is no. But from the long-term perspective, the risk is quite negligible, at least according to history. Forget about debt instruments! If your portfolio holds a couple of regular or active mutual funds, you can diversify your portfolio with index funds. The mixture of other mutual funds and index funds can be a passage where you can minimize your capital risk and maximize growth for a long-term horizon. Let us discuss why you should invest in index mutual funds briefly in this article.
What are Index Funds?
Index funds are classified under passive mutual funds. An index fund typically tracks a stock index (like SENSEX, NIFTY50, etc.) and invests in stocks with almost a similar weightage to that index. Such as a NIFTY Index Fund will only invest in those stocks that fall under the NIFTY-50 index with the same proportion. Unlike an active mutual fund, these funds involve less managerial interaction. Since the expense ratio of these funds is less compared to active mutual funds. If you want to make high returns in a rallying market or diversify your portfolio, an index fund is an excellent option to start with.
Also Read: PPF vs ELSS: Detailed Comparison & Which is Better
Why should you invest in Index Funds?
- Lower Management Cost
Index funds are comparatively cheaper than other mutual funds because of the expense ratio. When an active mutual fund charges around 0.5 to 1% or even higher for their direct plan, an index fund charges near about 0.2% annually. In the long term, this difference can make a significant impact on returns. Let's take an example:
Mr. A is running an investment under the UTI Nifty Index Fund with a monthly SIP of Rs. 10,000. His investment horizon is 20 years. He is paying a 0.2% annual expense ratio to UTI MF.
On the other hand, Mr. B is also running the Rs. 10,000 SIP with the same investment horizon under a different mutual fund that costs about a 0.5% expense ratio per annum.
For the calculation purpose, we are assuming both funds maintained 11% compounded annual growth. Let's see the corpus difference between Mr. A and Mr. B after 20 years.
After 20 years, the corpus of Mr. A will be roughly about 1.28 Cr., and Mr. B will have approximately 1.23 Cr. which is significantly lower than Mr. A. So, it's a good idea to pick MFs with a lower expense ratio which impacts very big in the long term.
- Simple & Transparent
Index funds are simple as they follow a particular index. If an index consists of 30 stocks, the fund should have those 30 underline stocks with the same proportion. So, if any company gets discarded from an index, it will also impact the fund itself immediately. If you believe the value of the index will rise in the future, the NAV of the corresponding index fund will also rise.
- Equity Exposure with Limited Risk
The risk of index funds is limited as stocks under an index are already filtered with various criteria. Due to their passive nature, these funds are less volatile compared to active mutual funds. When we see the history of an index like SENSEX and its growth over a long period, it's quite predictable that SENSEX will rise even in the future.
- Diversifying Investment Portfolio
Index funds can be a great instrument to make an investment portfolio diversified. As stocks under a market index are always dynamic and always consist of sectorial or segment leaders, an index fund requires less attention even when markets are at high or lows. If you invest in active equity mutual funds, you can still have an index fund to make your portfolio less volatile and more stable for the long run. Index funds are pretty good for those who have just started investing in mutual funds and have limited knowledge of equity markets.
Who can invest in index mutual funds?
Anyone willing to invest in equity using mutual funds can invest in Index funds. Index mutual funds are purely passively managed funds, so the growth potential of these funds over actively managed funds is comparatively low over the long term. So, it does not make any sense to invest the entire capital into index mutual funds. A combination of active and passive mutual funds according to risk appetite is ideal for long-term investment.
An index fund can be a good equity investment option for those whose equity investment is just about to begin. These funds are extremely simple and less risky than active mutual funds. Beginners, including risk-averse investors, can start investing with index funds, and later on, they can split their investment or SIPs over other mutual funds.
What is the ideal time to invest in an Index Fund?
If your perspective is for long-term investment, then timing is not a big deal. You can start a SIP or make a lump sum any time. In the stock market, funds certainly face ups and downs, but in the long run, you can expect a stable and risk-adjusted return. But buying a NAV at a lower price certainly makes sense for a better return. From this perspective, investing in an index fund during a market correction can even better.
How to pick an Index fund?
Index funds are simple and do not require much managerial interaction. The main focus of these funds is to follow a certain index and generate returns similar to that index. Here are three things that you should check before investing in an index mutual fund:
- Higher AUM (Assets Under Management)
Higher AUM means higher returns or a great mutual fund. No! That's not always true. AUM is not a benchmarking factor for a mutual fund. But a mutual fund with a higher AUM can be a good choice for the following reasons:
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You can expect better liquidity benefits as large AUM funds can bear a large number of redemptions. Most importantly, returns from a small AUM index fund can heavily be impacted on large redemptions. So, it makes sense to invest in a trusted and higher AUM-based index fund for better and consistent returns.
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Higher AUM means the fund is already popular enough that people have trusted and invested in that particular fund.
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- Lower Tracking Error
A stock index is nothing but a combination of stocks decided by the index committee. An index mutual fund blindly follows a particular stock index and invests in only stocks that fall under that index. And this is a continuous process. Stocks under an index may change from time to time and corresponding index funds also need alteration accordingly, which is a little bit time-consuming. This is one of the reasons why tracking error happens. The lower tracking rate denotes the stable performance of an index fund. And it’s natural, low-tracking error-index funds have the potential to generate similar returns as the index. If you are thinking of investing in an index fund, it is advisable to choose a low annual tracking error-based index fund for consistent returns.
- Lower Expense Ratio
The expense ratio is the management fees usually charged by a mutual fund house. Passively managed funds charge comparatively lower than actively managed funds. It is good to pick a fund with a lower expense ratio. But a lower expense ratio does not ensure that a fund will produce a better return. A reputed and consistent index fund can have a higher expense ratio. So, a fund with a great past and lower tracking error is a safer option for the long run.
Taxability of Index Mutual Funds
Let us discuss another but pretty important aspect of taxation of index funds, namely capital gain taxes. Index funds are classified as equity mutual funds, so the taxability of index funds is equal to that of other equity mutual funds. Taxes on equity funds is called capital gain tax and applicable if you redeem, transfer, or switch from it.
Short Term Capital Gain (STCG) tax is applicable on holding an index fund for less than one year. On the other hand, if you sell or transfer it post one-year, Long Term Capital Gain (LTCG) Tax will be applicable. For equity mutual funds STCG tax is fixed 15%. While long-term capital gains up to 1 lakh is free from tax. However, 10% LTCG tax is applicable if the capital gain exceeds 1 lakh during a financial year.
Which is better: Index funds or ETFs?
Index funds and ETFs are almost similar types of passive investment tools. Like index mutual funds, ETFs also invest in an underlying stock index. So, it is practical to raise a question, which is better and why? Well, both options have their pros and cons. However, I would like to point out the aspects that make the index fund better than the ETFs.
Low expense ratio myth in ETFs
It's a fact that ETFs come with a very low expense ratio, even less than index funds. But there is another charge included with ETF, i.e., brokerage cost. ETFs are traded in the secondary market through brokerage houses. Therefore, broking charges should also be considered along with your expense ratio to compare with index funds.
Liquidity
The main problem with ETFs is they have some liquidity issues. Sometimes, you might face no buyer when you try to sell your holdings or vice versa. Usually, open-ended index funds do not face this liquidity issue as they maintain a certain cash reserve. But this can also make the return of an index fund compromised. But for individual investors, index funds are a more convenient option than ETFs.
Easy to Invest
An index fund works like any other mutual fund and does not require a Demat account. All you need to have your PAN number and address proof, and you are ready to invest in index funds. If you do not invest directly in stocks, I think, there is no point in opening or maintaining a Demat account as it includes some additional charges like annual maintenance, brokerage, etc.
5 Top-performing Index funds in India
| Fund Name | AUM (Cr.) | 3 Year Return * | 5 Year Return * | Expense Ratio |
| UTI Nifty Index Fund | 4,021.83 | 14.12% | 14.58% | 0.2% |
| ICICI Prudential Nifty Index Fund | 1696.95 | 14.01% | 14.32% | 0.1% |
| HDFC Index Nifty 50 Plan | 3343.13 | 13.99% | 14.50% | 0.2% |
| SBI Nifty Index Fund | 1274.67 | 13.78% | 14.33% | 0.17% |
| HDFC Index Sensex Plan | 2262.35 | 14.27% | 15.03% | 0.2% |
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