Index funds are inexpensive and carry lower risk than a direct investment in shares or actively-managed equity funds.

An index typically measures the performance of a group of assets and a mutual fund that follows a particular market index like the Sensex, Nifty 50, S&P 500, etc. is called index fund. In a regular equity mutual fund, the fund manager actively manages the portfolio that may result in underperformance or overperformance compared to the underlying index. However, in an index mutual fund, the portfolio is passively managed by the fund manager and is a replica of the underlying index.

Index funds are inexpensive and carry lower risk than a direct investment in shares or actively-managed equity funds. An index fund can be highly efficient when you invest in it for the long term.

That being said, there are some important points that you should keep in mind before you start investing in them.

Evaluating an index fund’s performance

The performance of an index fund should be as close to its index as possible. The best index funds are those that exactly copy the performance of its index. For example, suppose an index fund follows the Sensex for its investments. If the Sensex rises by 5% in a month, then that index fund should also increase exactly by 5%, and if the Sensex falls by 5%, the index fund should also drop by the same 5%. If there is a change in the index structure, the index fund should follow and make the exact change in its portfolio structure. The margin by which the index fund fails to match its index is called tracking error. The lower the tracking error, the better it is when you select the index fund.

How much is the expense ratio?

As mentioned earlier, index funds are passively managed; therefore, their expenses ratio is usually much lower than the actively-managed equity funds. When comparing different index funds in the same category, you should analyse their expense ratios, return potential and the return potential of the index they follow. A high expense ratio normally reduces the return compared to the underlying index.

Invest for the long term

An index may not perform well for one year but do well in the next year. Similarly, many indices tend to perform better in the long term compared to the short term. Therefore, if you are planning to invest in an index fund, you should focus on a long-term investment horizon.

Know the associated risks

Sometimes actively managed funds may do well compared to index funds, especially when the market is volatile. An index fund follows its index, and there is no way to cut the losses when the market is volatile because they are passive funds. So, when there is a fall in the index value, you can’t expect your index fund to do better; however, that’s not the case when you invest in an actively-managed equity fund.

Tax on index funds

Index funds are taxed similar to equity funds. Gains on investments for less than one year are called short-term capital gains (STCG) and greater than one year are called long-term capital gains (LTCG). The STCG is taxed at a 15% rate while LTCG exceeding Rs 1 lakh in a financial year is taxed at a 10% rate. The LTCG below Rs 1 lakh in a financial year is tax-exempt.

Final thoughts

While investing in index funds, you should assess it differently from the actively-managed mutual funds. Investing through an SIP (systematic investment plan) mode in an index fund can help you reduce the volatility risk and benefit from rupee cost averaging while investing for the long term. If you are looking for a moderate return in sync with the index return in the long term, investing in a top-rated index fund can be an attractive option for you. However, if you are ready to take a high risk, looking for a high return, and want to outperform the underlying index, you may consider an actively-managed equity fund instead of an index fund. Always invest according to your financial goals, liquidity requirements and risk appetite in multiple instruments across various asset classes, and don’t hesitate to consult a certified investment planner if you’re unsure about anything.