Index funds were introduced to address the challenges faced by investors in selecting a portfolio of securities that aligns with their financial goals. In today's market, with a wide range of companies listed on the stock exchange and various sub-categories based on market caps, themes, risk profiles, and credit ratings, the choices available to investors are abundant.

However, navigating through these options and continuously evaluating their risk profiles, growth prospects, and valuations can be daunting for investors. The process of active stock selection carries its own set of risks and requires expertise and continuous monitoring. Many investors may be hesitant to take on this stock selection risk altogether.

To cater to such investors, asset management companies (AMCs) have introduced index funds, which provide a passive investing model. These funds track and attempt to replicate the performance of a market index, eliminating the need for investors to individually select and manage securities. By investing in an index fund, investors can mitigate the active stock selection risk and gain exposure to a diversified portfolio of securities that align with the performance of the chosen index.

Index mutual funds come in different types – equity-based and debt-based. Equity-based can be further categorised based on market caps, themes and sectors, strategy, etc. The key benefit of index funds is the combination of diversification at low minimum investments, similar to other mutual funds, along with the advantage of lower active stock selection and lower costs.

An index fund is a type of mutual fund whose objective is to track and mimic the composition and performance of an underlying index of securities, at as low tracking error as possible. An index is a basket of securities – can be stocks or debt instruments, that represent a specific theme or category of the marketsuch as NSE Nifty, BSE Sensex, etc. Different indices are drawn up by the stock exchanges from time to time to represent different market segments and to serve as benchmarks for several financial analysis. For example – the NIFTY 50 Index represents the top large-cap companies on the market, on the other hand, the NIFTY Small Cap 50 Index represents the top 50 companies in the small-cap segment.

An index fund follows a passive investing strategy to provide investors with returns that align with returns earned by the underlying index being tracked. In order to replicate the performance of the chosen index, the fund manager maintains a portfolio that closely mirrors the composition of the underlying index, investing in the same securities and maintaining proportional weights without making changes to the portfolio composition.

We mentioned above that index funds in India follow a passive investing strategy. Let us understand what this means. Mutual funds can be managed actively or passively. Active management in mutual funds involves a fund manager making tactical decisions on which securities to buy or sell based on their expertise. This approach requires frequent transactions and is known as active investing. Passive management, on the other hand, involves replicating the portfolio of a specific index and maintaining proportional allocations to individual stocks. Fund Managers in passive investing cannot choose stocks freely and instead aim to replicate the chosen index.

Index funds follow a passive investing model. When you invest in index funds, the fund manager invests the fund’s corpus in the same securities and in the same proportion as are found in the underlying index.

Indices are re-balanced and re-constituted periodically. In line with this, the fund manager also re-aligns the fund’s portfolio composition by selling outgoing securities and buying incoming securities of the index.

Through this strategy, index funds look to earn returns similar to those returned by the underlying index, subject to tracking errors.

For example, a NIFTY Index Fund invests in stocks of companies that make up the NIFTY 50 Index in proportion to their weights in the index. The objective is to achieve a return equivalent to the benchmark NIFTY 50 Index. For instance, if Tata Motors has a 14.6% weightage in the NIFTY 50 index, the fund manager of the NIFTY Index Fund will allocate 14.6% of the portfolio to Tata Motors stocks. The same proportional allocation will be maintained for other stocks in the index.

In a passively managed index fund, the fund manager replicates any changes that happen in the index. If a stock's weightage increases or decreases in the index, the fund manager also adjusts the holdings in the index fund portfolio accordingly. Similarly, if a stock is removed from the index and replaced with a new stock, the fund manager sells the removed stock and purchases the new stock in the same proportion as it appears in the index.

Index funds offer several benefits to its investors, which include:

• Single access point to diversified securities of a specific theme

  Index funds give portfolio exposure to a diversified cross-section of securities that are found in the index through a single investment tool.

• Periodic rebalancing - Follows ‘principle of natural selection’

  By tracking a market-driven index, these funds allow market behaviour to govern stock selection. This keeps you invested in top movers of the market through a passive investing model.

• Reduced active stock selection risk

  By simply tracking the index, these funds eliminate the element of human bias in stock selection, thus it is not susceptible to ‘active stock selection risk’

• Liquidity

  With no entry load and generally no exit load (typically nil after 90 days), investments in index funds offer investors liquidity throughout the tenure of the fund. Their units can in fact be bought and sold through both regular and direct plans.

• Low minimums

  Like most mutual funds, index funds give wide portfolio access at low minimum investments – as low as Rs.500.

• Reduced investing costs

  A passive investing strategy allows index funds to have a low total expense ratio, reducing the cost of investing.
  Also learn about : What is ELSS Fund?

Index funds are a suitable choice for the following types of investors:

• Investors seeking a hassle-free investment approach

  Unlike actively managed funds, index funds do not require continuous tracking of performance. With index mutual funds, the portfolio and performance are directly linked to a specific index. Since the fund's holdings mirror the composition of the underlying index, it eliminates the need for frequent reviews and monitoring. This makes it a convenient option for investors who prefer a hands-off approach without the need for active stock selection. By choosing index funds, investors can enjoy a hassle-free investment experience while still participating in the overall market performance.

• Investors satisfied with market-level returns’

  If you are content with the returns offered by the overall market and do not wish to take on additional risk in pursuit of higher returns, index funds are well-suited for you. These funds replicate the performance of a specific market index, ensuring that the returns generated closely align with the market itself. Therefore, index funds are particularly beneficial for novice investors who aim to earn market-linked returns that are more or less at par with those earned by the index.

• Investors looking to minimize human bias

  Investment decisions made by individuals can be influenced by personal biases. Fund managers may have their own beliefs and convictions, which can impact their investment choices. Index funds, on the other hand, eliminate human bias from investment decisions. They simply replicate the index based on predetermined rules, providing a way to achieve unbiased investing. It also minimizes active stock selection risk.

Advantages of Index Funds in India

• No Bias Investing

  Index funds follow an automated, regulation-based investment approach. The fund manager replicates the specific index being tracked, eliminating any bias with regard to stock selection. The fund invests in all the stocks comprising the index, with individual weights matching their proportions in the index. Since the fund manager does not have to personally choose stocks or time entry and exit points, there is no risk of personal bias. This provides investors with a transparent and objective investment strategy.

• Low Cost of Investment

  Best index mutual funds offer a significant advantage of low investment costs. These funds have comparatively lower expense ratios due to their passive management approach. Since index funds replicate their underlying benchmarks, they do not require a team of research analysts to select stocks or determine the optimal entry and exit points. As a result, these low cost index funds are an attractive choice for investors looking to maximize their long-term investment gains.

• Broad market exposure

  Top index funds in India provide investors with diversified investments across various sectors, stocks, industries, market caps, and investment themes. Indices typically consist of a basket of diversified stocks, with limitations on individual stock exposure. This ensures that investors can benefit from broad market exposure through a single index fund. For example, investing in a Nifty 50 index fund offers exposure to the top 50 stocks on the NSE spanning 13 sectors, ranging from automobiles to pharmaceuticals and banking. This diversification helps mitigate concentration risk and allows investors to capture potential returns across a larger segment of the market.

You can invest in index funds by following these simple steps:

• Login on ABSL app or website

  Download and install the ABSL app on your mobile device or visit the website to create a login/signup account.

• Select the desired index fund

  Choose the best index funds in India you want to invest in by browsing or searching for them.

• Select investment mode

  Choose your preferred investment mode: lump sum or Systematic Investment Plan (SIP).

• Make payment and begin investing

  Make the payment securely using Net Banking or UPI and begin investing in the best index funds instantly.

When considering investments in the best index funds in India, it is important to take into account the following key factors:

• Risk Tolerance

  Index funds generally carry lower volatility and are less prone to equity-linked risks compared to actively managed funds, making them suitable for investors seeking stable returns during a bullish market. However, to mitigate this risk during market downturns, you may consider having a diversified portfolio that includes a mix of both index funds and actively managed funds.

• Expected Returns

  When considering the best index funds to invest in, it is important to assess the expected returns. While index funds aim to replicate the performance of the underlying benchmark, tracking errors can lead to deviations from the actual index returns. To maximize performance, it is recommended to shortlist top index funds in India with minimal tracking errors, as lower errors are indicative of better fund performance.

• Expense Ratio

  When evaluating best performing index funds for investment, it is crucial to consider the expense ratio. Index funds typically offer a significant advantage in the form of a low expense ratio compared to actively managed funds. Since index funds do not require extensive research or stock selection, the costs associated with fund management are reduced, resulting in a lower expense ratio. Choosing a fund with a lower expense ratio can lead to comparatively higher investment returns.

• Investment Horizon

  The investment horizon is an important consideration when investing in the best index funds in India. These funds are well-suited for individuals with a long-term investment horizon of say more than seven years. While index funds may experience short-term fluctuations, they tend to average out and generate significant returns over the long-term. It is crucial to have patience and remain invested for a longer duration to fully realize the potential of the fund. Aligning long-term investment goals with index funds helps navigate short-term market volatility and maximize investment outcomes.

• Taxation

  Tax implications should be considered when investing in index funds. Index funds, being equity funds, are subject to a dividend distribution tax (DDT) of 10% on dividends paid. Additionally, capital gains tax is applicable when redeeming units of an index fund. Short-term capital gains (holding period of up to one year) are taxed at 15%, while long-term capital gains (holding period of more than one year) up to Rs. 1 lakh are exempt from tax, and any amount above this is taxed at 10% without indexation benefits. It is important to understand and account for these taxes when evaluating the potential returns of an index fund investment.

Index funds are suitable for:

- Investors looking to minimise active stock selection risk and incur lower costs than actively managed mutual funds

- Investors, especially novice investors looking to earn market-linked returns that are more or less at par with those earned by the index

- Investors looking to invest in a specific segment or theme without taking on the hassle of active stock selection