What are Index Fund: Meaning, Advantages & Types Explained

Let us recall two very famous sayings of Warren Edward Buffett, an American investor, business tycoon, and philanthropist.

1) If you like spending six to eight hours a week working on picking your investments, you might as well do it. But you might not be fortunate enough to spend so many hours on finding the perfect stock. So if you don’t have time, then dollar-cost averaging into index funds is your best shot.

2) If your returns will be 7 to 8%, and you end up paying 1% towards fees, it makes an enormous difference in the amount of money you will have with you when you retire.

If you didn’t understand the above two quotes, don’t worry. We will start with the basics.

What is an Index Fund?

An index fund is comparable with a mutual fund that provides returns consistent with the market index. As the Standard & Poor 500 is an index in the United States, India has two benchmark indices. They are BSEThey are BSE Sensex and NSE Nifty. The sums of money of the investors are allocated systematically to all the securities that constitute a particular market index Sensex and NSE Nifty. The sums of money of the investors are allocated systematically to all the securities that constitute a particular market index. It is as if the index fund is mimicking or mirroring the returns of the market index.

To explain the concept of index funds better, imagine you have saved money to invest in stocks. But you happen to be a beginner at stock investing and don’t have the time to identify multibaggers. What if you could still invest in all the blue-chip stocks listed on the exchange, which constitutes the index? That is what index funds do for you. With how-much-ever money you decide to invest, you can safely invest it in index funds, provided it meets the minimum investment amount of the fund. The fund manager will allocate your invested amount to the companies forming a part of the index – and all this will be done on your behalf by your fund manager, without you having to go through the efforts of doing it yourself.

What is Index Fund Investing?

The people who allocate their money to index funds believe that it is challenging and rather improbable for a single stock to beat the performance of a market index. They believe that the market will outmatch every stock in the long term, making it a more substantial bet. Index fund investing is more manageable and is especially recommended for beginners. There is no need to consistently time the market or even read charts to analyze the portfolio technically. One does not have to read quarterly financials and update portfolio constituents themselves. Index fund investing is simply purchasing the index, i.e., all the stocks in the index. You can decide whether your investment is short-term or long-term and make decisions accordingly.

Types of Index Funds

  1. Broad Market Index Funds: These funds follow broad market indices like the S&P 500, covering a wide array of stocks from different sectors.
  2. Sector-Specific Index Funds: These funds concentrate on specific sectors such as technology, healthcare, or finance, mirroring indices linked to those sectors.
  3. International Index Funds: These funds invest in global stock markets, replicating indices like MSCI World or FTSE Global All Cap.
  4. Bond Index Funds: These funds mirror bond indices, providing exposure to fixed-income assets like government or corporate bonds.
  5. Commodity Index Funds: These funds invest in commodities like gold, oil, or agricultural products, following respective commodity indices.

6. Dividend Index Funds: These funds focus on stocks with high dividend yields, tracking indices centred on dividend-paying firms.

How do Index Funds Work?

Suppose HDFC Bank Ltd. has a weightage of 11% in Nifty 50. To replicate the returns of this market index, a Nifty 50 Index Fund will also allocate 11% of its portfolio to HDFC Bank Ltd. And this fund will only invest in the 50 companies that constitute the index. As and when the constitution of the index changes, the fund managers also make adequate changes to the portfolio. Hence, an index fund is passively managed.

As index funds are passively managed, there is a very significant advantage associated with them. These funds do not contain the risk of being influenced by the decisions of the fund managers. This way, the returns generated by the fund are never affected by wrong fund manager decisions. Hence, you make money whenever the index moves in your favor.

Advantages of Index Funds

Let us understand how investing in index funds can make your life more comfortable.

1) Reduced expenses

A typical mutual fund has to incur several expenses – salaries of research analysts and trade advisors, transaction costs, and other charges associated with taking a trading position. What happens as a result of these exorbitant expenses? Investors receive lesser income on their investments as a part of their income is apportioned towards meeting the running expenses of the fund.

But, a passively managed fund like an index fund incurs substantially fewer expenses. As the fund is designed to replicate a market index, hiring advisors, researchers, and analysts is no requisite. Furthermore, portfolio churning is not frequent. Hence, transaction costs like brokerage and taxes are reduced.

Passive management benefits investors by providing better returns. Remember, the objective of an index fund is not to beat the market. It does not need to incur expenses to have a chance at overtaking the market. Instead, an index fund aims to achieve the same return rate and risk rate as the market. So you grow when the market grows.

2) Diversification of portfolio

Diversification is crucial because investors do not risk losing all of their money due to a wrong investment decision. When you allocate small amounts to different securities, you no longer have to bear that risk. Index fund investing is the most economical way of diversifying funds into an index.

Index funds provide stability to investors. It works excellent for long-term portfolios, generally seven years or more, but that is a personal choice. Be careful of the tracking error of your fund, i.e., the difference in the return of the fund and the market index. The fund manager must work towards bridging the gap and providing increased returns to investors.

  1. Index funds offer straightforward investment strategies that are easy to understand. Unlike actively managed funds, which can involve complex trading strategies and frequent adjustments, index funds aim to replicate the performance of a market index, making it easier for investors to grasp the fund’s objectives and management approach.
  2. Index funds provide investors with transparent access to information about the fund’s underlying holdings and performance relative to the benchmark index. This transparency fosters trust and confidence in the investment strategy, allowing investors to make informed decisions based on readily available data.

However, it’s crucial to monitor the tracking error of the fund, which reflects the variance between its returns and the market index. Fund managers must work to minimise this difference to ensure investors receive optimal returns aligned with the index’s performance. Ultimately, index funds offer a cost-effective way to attain market returns while spreading risk, making them a valuable asset in any investment portfolio.

Who should invest in an Index Fund?

Index funds are designed to generate returns that are similar to those offered by the index. Hence, it satisfies the investment needs of a wide variety of investors.

Beginner investors: Index funds are often recommended to beginner investors. These funds provide a simple way to gain exposure to a broad market without the need for in-depth knowledge of individual stocks or extensive research. 

Passive investors: If you believe in the theory that it is difficult to outperform the market consistently, then index funds align perfectly with the passive investment strategy. 

Index fund investors are happy to receive market returns without trying to beat the index.

Long-term investors: Index funds suit the needs of investors with a long-term investment horizon, such as those saving for retirement or other long-term goals. Over a period of time, index funds have generated more returns than equity funds due to low investment costs. 

Diversification seekers: Index funds are inherently diversified. They invest in a basket of stocks representing the specific index or sector they track. This diversification helps reduce the impact of poor performance by any single stock.

Taxation on Index Funds

Taxes on index funds are levied on both dividends and capital gains. The dividend is included in the investor’s income, and the entire sum is taxed as per the calculated tax slab for the income bracket. 

Capital gains, however, are taxed separately. It is calculated based on the duration of the holding period. The short-term capital gain tax is levied when the investment period is less than 12 months. A 15% tax rate applies to the short-term gain. Similarly, long-term capital tax will apply when the holding is for more than one year. A tax rate of 10% is charged if the gains exceed ₹1,00,000. 

The tax is payable when the investors redeem the units.

Factors to consider before investing in Index Funds in India

If you are planning to invest in index funds, these are factors that should be on your mind. 

Risk and returns: Index funds are passively managed funds that follow a market index and invest in the same basket of stocks. Hence, these are less volatile compared to equity funds. Moreover, the fund generates returns similar to those of the index. 

Expense ratio: The expense ratio is the percentage charged by the mutual fund company to manage your investment. Since index funds are passive investment funds, the charges for managing the funds are low, which means more money in the investor’s pocket during the final returns.   

Investment objective and time horizon: Your investment horizon will influence the choice of index funds, as longer horizons allow for more exposure to equity-based indexes.

Past performance: Reviewing the historical performance of an index fund can provide insights into its consistency and ability to track its benchmark effectively.

Tax implications: Understanding the tax treatment of the fund will help you make an informed decision. Equity index funds held for more than a year qualify for long-term capital gain tax benefits. 

Final takeaways

An index fund is a great mechanism available to investors who want to invest in equities without taking a high quantum of risk. It provides consistent returns and does not require the investor to devote time to investment management. They are liquid and hence support both short-term and long-term investors. But before you invest in index funds, understand your objectives and define your goals. If possible, set your investment tenure so that you have a clear idea in your mind. Understand that even though these funds do not carry the possibility of earning prodigious returns by overhauling the index, they give consistent returns over time.


Are index funds good investments?

While actively managed funds try to outsmart the market index, index funds generate returns similar to those of the index. It’s been observed that index funds have generated better returns than actively managed funds in the long run. 

Are index funds safe?

Index funds are low-risk investments compared to equity funds since they invest in the same basket of stocks as the index. However, there are still risks involved in investing in index funds.

How do index funds work?

An index fund works by investing in the same stocks or securities in the same proportion as the index it aims to replicate.

Is an index fund a tax saver?

If it is an ELSS index fund, investors can receive tax deduction benefits up to ₹1.5 lakh under Section 80C of the IT Act every financial year.

Can I start a SIP on index funds?

Yes, it is possible to invest through a systematic investment plan or SIP. Index funds are mutual funds that invest in the same stocks as the index they follow.