What Is an Index Fund & How Does It Work?

Published On: 24-Mar-2020

When one is investing in equity markets through mutual funds, one is exposed to two types of risks – systematic risk and unsystematic risk. While systematic risk denotes the risk of changes in the macroeconomic environment impacting the investment portfolio, unsystematic risk refers to the risk of choosing a wrong company to invest in, thus making a wrong investment decision. Index funds are one of such mutual fund schemes, which help you eliminate the unsystematic risk and thereby, mitigating the overall investment risk. This article aims to demystify the concept of an index fund.

What is an Index Fund? 

Index funds are such funds that replicate a specific index in their investment portfolio so that the investors may aim to generate similar returns as being generated by the index it is replicating. The indices which might be tracked by such index funds may include NSE Nifty50, S&P BSE Sensex etc. As such, index funds are suitable for the investors with longer investment horizon who are comfortable with the returns generated by broader market indices, instead of aiming to outperform the market. Since the portfolio of index funds will be same as the composition of the underlying index, such funds will not be able to generate any alpha in the market. For example, assume NSE Nifty 50 generated a return of 15% in a year, an index fund tracking Nifty will also generate similar returns for the investors, subject to tracking error and expense ratio.

How does an Index Fund Work?

An index fund works on a passive investment strategy, wherein the fund manager does not have any flexibility to select stocks or decide their proportion in the portfolio. For example, if an index has 5% weight for Company A and 8% for Company B, the fund manager does not enjoy any liberty to invest in Company C or even invest 10% in Company A. An index fund must keep at least 95% of the portfolio invested in similar composition as that of the underlying index. Any fresh inflows/ redemption flows in an index fund are suitably invested/ liquidated to maintain the index composition. 

Further, the fund manager must track the underlying index for any changes over the period and make suitable changes in the fund portfolio. As such, whenever the index composition changes, the fund manager must rebalance the portfolio according to the modified index composition. Given a minimal role of the fund management team in devising the investment portfolio, such funds also carry a low Total Expense Ratio (TER). 

Investing in Index Funds

One may invest in index funds in the same manner as investing in other mutual fund schemes. As such, one may invest by submitting application forms physically in the official Points of Acceptance for the fund house or by visiting the website of the fund house. 

Taxation of Index Funds

Index funds are taxed as equity-oriented funds. Accordingly, any short-term capital gains with an investment period of less than 12 months are taxed at a special rate of 15% (plus applicable cess and surcharge). On the other hand, long term capital gains with an investment period of 12 months or more are liable for a tax rate of 10% (plus applicable cess and surcharge). Income tax laws also provide for an aggregate exemption of Rs. 1 lakh a year for all long-term capital gains from equity shares and equity-oriented mutual funds taken together, including index funds. 

Since the passive investment strategy seeks to eliminate any emotional and human bias from the investment process, thereby mitigating the investment risks. As such, index funds emerge as low-cost investment products seeking investment exposure to broader market indices.

Disclaimer: The tax benefits as mentioned in the article are for illustrative purposes only and are updated as per Union Budget 2020 presented by the Govt. on 1st Feb. 2020. Contact your tax advisor for more details.