Guide to investing in Index Funds

Equity investing is difficult and requires skills and expertise. This is where a fund manager’s skill and acumen help to outperform the market. But another category of mutual funds–index funds–take a different approach. They track an index and invest in stocks that make up an index, like say Nifty 50.

These types of funds are useful for investors who aren’t well-versed with stock markets, and the various categories of mutual funds. Index funds are a low-cost way of investing in the stock market by mimicking a portfolio of an underlying index.

What Are Index Funds?

An index is constructed by choosing stocks that meet a certain set of criteria. In this way, it provides a standardised way of tracking the performance of a market segment or the entire market. 

Index mutual funds try to replicate the performance of an underlying index by investing in companies in the exact same proportion of the index. For example, a Nifty 50 index fund will invest in all 50 stocks contained in the Nifty 50 index. This type of passively managed fund aims to offer broad exposure to the equity markets while keeping the expenses of investing low. 

Types of Index Funds

Now that you have a basic idea about index funds, let us discuss their various types: 

1. Broad Market Index Funds

A broad market index fund provides investors with broad exposure to the stock market across various sectors and market capitalisations. Investors usually diversify their portfolios by investing in these index funds.

2. Equal Weight Index Fund

Many indices that track a basket of stocks are usually given weights based on market capitalisation, free float market capitalisation, etc. Index funds that track such indices invest in stocks based on their weight in such indices. Equal-weighted index funds track an index that has underlying stocks in equal weight, rather than based on any other factor like market capitalisation.

3. Sector-Based Index Funds

Mutual funds that replicate indices formed based on a particular sector like healthcare, technology, infrastructure, banking, etc., are known as sector-based index funds. These funds allow investors to take concentrated exposure in sectors that they hope to perform well.

4. International Index Funds

International index funds are mutual fund portfolios that invest in stocks of companies listed outside India. These foreign market indices may include NASDAQ, S&P, Russel, etc. Through such funds, investors can get exposure to participate in an internationally diversified portfolio.

       5)   Bond Index Funds

Bond index funds replicate the performance of specific bond indices that list bonds offered by various government and private companies. Investors who want to invest in a structured bond portfolio underlying such indices.

Why Invest in Index Funds?

Here are some reasons why some investors choose to invest in index funds:

• Opportunity to Diversify Investment Portfolio

Investing in index funds can help in diversifying your investment portfolio by investing across several companies. This way, one can compensate for the risk of loss from a company's performance. It helps in avoiding risks associated with investing in individual stocks, or a concentrated stock portfolio through a mutual fund.

• Lower Cost

Index funds are passively managed by fund managers who mimic a particular market index. Therefore,  less research and effort are required compared to active management. As a result, the expense ratio of investing in index funds is lower.

• Tax Benefits

Index funds attract capital gains tax depending on the holding tenure of the units sold. Short term capital gains are taxed at 15% and long term capital gains of above Rs 1 lakh are taxable at 10%.