Exchange-traded funds (ETFs) and Index funds are giving better returns race than actively managed large-cap funds in the recent past. In this article, we look at Index Funds in Detail. What is Index Mutual Fund? Index Funds in India? Compare Index Fund with ETF and Active Fund, Types of Index Funds,  How to choose Index Funds? How to buy Index Funds?

What is Index Fund?

An index is an indicator or measure of something, and in the stock market, it typically refers to how the stock market has performed For example Sensex is an index that captures the increase or decrease in prices of stocks of top 30 companies that are traded on the Bombay Stock Exchange or BSE while Nifty captures top 50 companies that are traded on NSE or National Stock Exchange. 

Index funds are funds that invest in an Index. These funds purchase all the stocks in the same proportion as in the specific index. So the performance of the Index fund depends on the performance of the Index. These funds will mimic the performance of the index so will not outperform the market.  These types of funds do not require active management. This means the expense ratio of these funds is very low. For example, UTI Nifty Index Fund, the Direct plan has an expense ratio of 0.2%. It is very low compared to active fund where you will generally find expense ratio between 1-3%(depending on  Direct/Regular Plan).

Difference between ETF and Index Fund

An exchange-traded fund or ETF  tracks an index like index mutual fund but trades like a stock on an exchange. ETFs price changes throughout the day as they are bought and sold throughout the trading day. To buy or sell an ETF, you need to have a demat and trading account.  

Our article What are Index funds? What are ETFs? Do Index Funds Work? explains the difference in detail.

Taxation of Index Funds

Taxation of these funds is the same as those of active funds. When you redeem units of index funds, you earn capital gains. The rate of taxation depends on how long you stayed invested in index funds called the holding period. Capital gains earned on the holding period of up to one year are called short-term capital gains (STCG). STCG are taxed at the rate of 15%. Capital gains on holding period of more than 1 year are called long-term capital gains (LTCG).  From 1 Apr 2018, LTCG  of more than Rs 1 lakh will be taxed at 10% without the benefit of indexation.

Who should invest in Index Funds?

The investment decision in a mutual fund solely depends upon your investment goals and risk preferences. These funds will give you returns matching the upside of the particular index. Index funds are ideal for investors who are risk-averse and want predictable returns. These funds do not require extensive tracking.

Compare Index Fund, ETF, Active Fund

The table below shows the comparison between Index Funds, ETF and Active taking SBI as an example as om 16 Dec. Please note the NetAssets, Expense Ratio and Return. Nifty 50 return are given in header with ()

Fund	Net Assets (Cr)	Launch	Expense Ratio (%)	1-Month Return (2.17)	3-Month Return (-6.03)	1-Year Return (6.85)	3-Year Return (13.68)	5-Year Return (13.24)	10-Year Return (15.34)
SBI Bluechip Fund	20287.28	14-Feb-06	1.98	1.31	-5.97	-2.33	10.21	16.22	17.16
SBI Bluechip Fund – Direct Plan	20287.28	1-Jan-13	1.32	1.37	-5.77	-1.3	11.47	17.37	–
SBI ETF Nifty 50	41811.72	20-Jul-15	0.07	2.17	-6.04	6.81	13.66	–	–
SBI ETF Sensex	13397.57	8-Mar-13	0.07	2.33	-5.38	9.39	14.04	13.16	–
SBI Nifty Index Fund	332.11	4-Feb-02	0.66	2.1	-6.21	6	12.67	11.95	13.96
SBI Nifty Index Fund – Direct Plan	332.11	1-Jan-13	0.26	2.13	-6.12	6.42	13.19	12.45	–

Types of Index Funds

There are following types of Index Funds.

• Nifty based fund: Follows Nifty Invests in 50 companies
• Sensex based fund: Follows Sensex. Invests in top 30 companies of Sensex
• Other Indices: Like Next 50

Sensex Based Index Funds

Fund	Launch	Expense Ratio (%)	1-Year Return (%)	Net Assets (Cr)
HDFC Index Fund – Sensex Plan	17-Jul-02	0.3	8.49	276.98
ICICI Prudential Sensex Index Fund	18-Sep-17	0.5	7.95	8.88
LIC MF Index-Sensex Plan	28-Nov-02	1.68	7.4	18.77
Reliance Index Fund – Sensex Plan	28-Sep-10	1.16	7.93	12.12
Tata Index Sensex Fund	25-Feb-03	0.46	8.49	8.65

Nifty Based Index Funds

Fund	Launch	Expense Ratio (%)	1-Year Return (%)	Net Assets (Cr)
UTI Nifty Index Fund – Regular Plan	6-Mar-00	0.2	5.93	1055.82
HDFC Index Fund Nifty 50 Plan	17-Jul-02	0.3	5.97	466.79
ICICI Prudential Nifty Index Fund	26-Feb-02	1	5.03	359.55
SBI Nifty Index Fund	4-Feb-02	0.69	5.5	332.11
Franklin India Index Fund – NSE Nifty Plan	4-Aug-00	1.09	4.81	248.48
IDBI Nifty Index Fund	25-Jun-10	0.99	4.44	221.02
Reliance Index Fund – Nifty Plan	28-Sep-10	1.16	5.14	135.71
LIC MF Index-Nifty Plan	28-Nov-02	1.25	4.33	19.93
Tata Index Nifty Fund	25-Feb-03	0.46	5.76	13.53
Taurus Nifty Index Fund	19-Jun-10	1.67	7.09	8.47
Quantum Nifty ETF	10-Jul-08	0.94	6.09	5.43

Index Funds not based on Sensex/Nifty 50

The NIFTY Next 50 Index represents 50 companies from NIFTY 100 after excluding the NIFTY 50 companies. The NIFTY Next 50 Index represents about 12% of the free float market capitalization of the stocks.

100 Equal Weight Index: Most stock market indices are market capitalization weighted indices. That is, higher the total market value of a stock, higher its presence (weight) in the index. The Nifty 100 Equal weight index is one in which all the stocks of the Nifty 50 and Nifty Next 50 are found in equal measure

Fund	Launch	Expense Ratio (%)	1-Year Return (%)	Net Assets (Cr)
ICICI Prudential Nifty Next 50 Index Fund	25-Jun-10	0.85	-7.67	327.42
UTI Nifty Next 50 Index Fund	22-Jun-18	1.06	–	278.5
Principal Nifty 100 Equal Weight Fund	27-Jul-99	1	-2.95	16.88
IDBI Nifty Junior Index Fund	20-Sep-10	0.78	-8.34	50.45

How to choose Index Funds?

Based on factors like Tracking Error and Expense Ratio

Tracking error: Tracking error tells us how much an index fund’s returns deviate from the benchmark index’s returns over any given period of time.  Lower the tracking error better is the index fund. It is the standard deviation of the difference between a fund’s daily return (in percentage term) and the benchmark index.

We could not find tracking errors being reported directly on any site. Formula for calculating tracking error is shown in the image.

Since an index fund is supposed to provide the same returns as the index, tracking error is a good way of measuring how well an index fund is run. A well-run index fund will generally have a small tracking error. Calculating tracking error is simple. What gives rise to a tracking error, after all, an index fund passively purchases all the stocks of a market index, in exact proportion: expenses, idle cash, and an inability to match the fund’s portfolio exactly to the index. 

Expense ratio: Lower the expense ratio better is fund performance

Assets under Management: For Mutual Funds just show the popularity of the funds.

How to buy Index Funds?

You can buy index fund like any other Mutual Funds through

• Through distributors offline
• Directly with the AMC offline and online
• Through Online Portals: There are several third-party online portals, from where you can invest in various mutual fund schemes across AMCs like MF Utility
• Through Demat and Online Trading Account

Related Articles:

• Stock Market Index: The Basics
• All About Mutual Funds: Basics, Choosing, Paperwork, Direct Investing explains
• Does Index Fund or ETF Work? Will it work in India
• What are Index funds? What are ETFs? Do Index Funds Work?