Index Funds

What are Index Funds? 

• Index Funds are mutual funds that track an underlying index e.g. Nifty 50, Sensex for equities, Nifty 10 yr Benchmark G-Sec for debt etc.
• In order to track the underlying index as closely as possible, Index Funds aim to own the same securities in the same proportion (weights) as the underlying index
• Index Funds are a simple way for investors to gain exposure to the equity and debt markets to earn market returns
• Investors do not need a demat account to invest in Index Funds – they can purchase / sell units of the Index Fund at End of Day NAV, just like ordinary mutual funds

How do Index Funds work?

The Index Fund Manager aims to own the same securities in the same proportion (weights) as the underlying index. The Fund Manager will rebalance the portfolio i.e. buy / sell securities as they move in / out of the index to ensure the fund is tracking the index as closely as possible.

Investors can purchase / sell units of the Index Fund at End of Day NAV, just like ordinary mutual funds. They can also set up Systematic Investment Plans (SIPs), Systematic Transfer Plans (STPs), Systematic Withdrawal Plans (SWPs) etc. as they would with other mutual funds.

What things should you consider as an investor?

First, investors need to assess if an Index Fund is suitable for them - will it help achieve their financial goals and does it match their risk tolerance? For example, if an investor is saving for retirement and has a long investment horizon, they may invest in Equity Index Funds. However, they need to have enough risk tolerance to handle market volatility and fluctuations along the way. On the other hand, if an investor’s financial goal is only a few months or years ahead, then they may consider investing in Debt Index Funds, which offer more stability but relatively lower returns on average.

The underlying index that the Index Fund tracks is mentioned in the ‘scheme name/type’ itself and the complete details are covered in the respective scheme’s information documents. Investors should first identify the kind of Index Fund that will help them achieve their financial goals. For example, do they want to buy an equity or debt Index Fund? Within equity, do they want exposure to a broad market index like the Nifty 50, Sensex etc., or to specific Sectors, Themes, Smart Beta investing etc.

Once they have identified the category that is suitable for them, they should keep the following in mind to choose a particular Index Fund:

1. Total Expense Ratio (TER) – This is the cost of running and managing a mutual fund scheme. All else equal, a lower TER is preferable as this results in lower costs for the investor
2. Tracking Error (TE) and Tracking Difference (TD) – These measure how well the ETF is tracking its benchmark
   1. Tracking Error (TE) is the annualized standard deviation of the difference in daily returns between the underlying index and the NAV of the Index Fund, based on past one year rolling data
   2. Tracking Difference (TD) is the annualized difference of daily returns between the index and the NAV of the Index Fund. TD over a given period is = ETF NAV CAGR (Compound Annual Growth Rate) – Benchmark CAGR
   3. A low TE and TD for Index Funds is preferable, as it shows the scheme is tracking its benchmark closely.