Index Funds - Definition, Risk and Returns

8 May, 2025

Synopsis

• Index funds track market indices, offering low-cost, passive investing.

• They replicate market indices, ensuring predictable performance without active management.

• Suitable for long-term investors, beginners, and those with low-risk tolerance.

• Key factors include risk, expense ratio, tracking error, and long-term goals.

Investing in the stock market can feel overwhelming, especially with constant market movements and endless stock options. Some investors prefer a hands-off approach—one that doesn’t require constant monitoring or complex strategies. This is where index fund comes in, offering a simple yet effective way to track market performance. This article explores how they work, who should invest, key risks, returns, and factors to consider before making a decision.

What are Index Funds? 

Index funds track a specific stock market index, say NSE Nifty or BSE Sensex. They have the same stocks as their base index and maintain the same weightage. Since they don't require active management, they have a lower expense ratio compared to actively managed funds. The primary objective is to replicate the index performance, giving the investor returns that are very similar to the market.

How do Index Funds Work?

When you invest in an index fund, your money gets invested in the stocks included in the benchmark index in the same ratio. For example, if an index fund tracks the NSE Nifty, it will have shares of all 50 companies in the same weightage as the index.

As opposed to actively managed funds, where fund managers buy and sell stocks regularly on the basis of market forecasts, index funds operate on a passive investment strategy. This implies that the fund does not try to beat the market but instead reflects its movements.

Who Should Invest in an Index Fund? 

Index funds are ideal for:

1. Long-term Investors Looking for Steady Returns with Lower Risk

Large-cap funds are the best for investors with a long-term perspective and who want consistent and stable returns. Large-cap funds invest in established companies with sound financials, minimizing volatility and offering dependable growth over a period of time. Large-cap stocks face fewer fluctuations compared to mid or small-cap stocks and are thus a better option for wealth accumulation.

2. Beginners Who Want a Simple Investment Option Without Constant Monitoring 

New investors can find the stock market overwhelming, but a large-cap fund is an easy option to invest in. As the funds invest in well-established firms, minimal research and observation are needed. Beginners can passively invest in funds, with expert fund management benefits, without needing any vast knowledge about the market.

3. Investors with a Low-Risk Appetite Who Prefer Predictable Market Returns 

Those who prioritise stability over high returns often choose large-cap funds due to their lower risk. These funds invest in companies with strong market positions, ensuring more predictable performance. Even during market downturns, large-cap stocks are less likely to experience extreme declines compared to smaller, riskier stocks.

4. Those Looking for Cost-Effective Investments with a Low Expense Ratio 

Cost-conscious investors prefer large-cap index funds, which provide market-linked returns at a lower expense ratio compared to actively managed funds. As these funds involve less trading, they have lower transaction costs, thus proving to be cost-effective. Lower expenses over a period of time result in higher net returns for investors.

Factors to Consider Before Investing in Index Funds in India 

Before investing in index funds in India, understanding key factors is crucial. While they offer a low-cost, passive approach, they also carry risks and tax implications. Here’s what to consider:

1. Risks and Returns

As index funds track the market, they are less risky than actively managed funds but do not provide outperformance. In bullish markets, the funds go up, but in bear markets, they plummet along with the index. One key thing to check is tracking error—the variance between the fund returns and its benchmark performance. A lower tracking error signifies greater effectiveness at replicating the index.

2. Expense Ratio 

The expense ratio is the fee charged by the fund house on an annual basis for managing the fund. Index funds need less active management and hence their expense ratios are much lower compared to actively managed funds. This makes them affordable, with more of your returns being invested.

3. Invest According to Your Investment Plan 

Index funds are most suitable for long-term investors, who usually have a time horizon of seven years and beyond. There are short-term swings in between, but given the historical evidence, the movement of the market over the years tends to even out and provide stable returns. If you align your investment with long-term needs, like retirement planning or wealth accumulation, index funds can be a good choice.

4. Capital Gains Tax

Index funds in India are taxed as equity funds, making it crucial for investors to stay updated on the latest tax regulations. The Union Budget 2024 has restructured the taxation of equity mutual funds, introduced revised rates and eliminated certain benefits. Below is a detailed overview of the new tax rules:

Short-Term Capital Gains (STCG) 

Gains from equity mutual funds held for less than a year are classified as short-term capital gains. Under the updated tax framework, these gains are now taxed at 20%, an increase from the previous 15%.

Long-Term Capital Gains (LTCG)

For equity mutual funds held for over a year, the following tax rules apply:

• Tax-Free Limit: Gains up to ₹1.25 lakh in a financial year remain tax-free (previously ₹1 lakh).

• Tax Rate: Gains exceeding ₹1.25 lakh are taxed at a flat 12.5% (earlier 10%).

• Indexation Removal: The indexation benefit, which previously allowed investors to adjust the asset's purchase price for inflation, has been eliminated across all asset classes, including equity mutual funds.

Previously, long-term gains on assets like real estate and gold were taxed at 20%, but investors could use indexation to lower their tax burden. The new system simplifies taxation by imposing a flat 12.5% tax on all long-term gains, but without indexation benefits.

5. Tax

Index funds, like other equity-based investments, are subject to dividend taxation in the hands of the investor if the fund house declares dividends. The dividend is added to the investor’s total income and taxed as per their applicable income tax slab. However, many investors prefer growth plans, where profits are reinvested rather than distributed as dividends, allowing for potential long-term capital appreciation.

Index funds provide a cost-effective means to build wealth gradually. Although they track market directions, being wise in your selection is essential. Invest easily with HDFC Sky—compare best index funds, track returns, and invest simply. Download the HDFC Sky app today and begin your journey to smart investing!

FAQs
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1. Are Index Funds better than actively managed funds?

It will depend on your investing goals. Index funds are inexpensive, and return linked to the market, whereas actively managed funds can perform better than the market but incur more costs and risks.

2. How do I select the best Index Fund in India?

Look for funds with a low expense ratio, minimal tracking error, and a well-established track record. Reviewing past performance and the fund’s benchmark can help in making an informed decision.

3. Can I invest in Index Funds through SIP? 

Yes, you can invest through a Systematic Investment Plan (SIP), allowing you to invest a fixed amount regularly, reducing the impact of market fluctuations.

4. What are the risks associated with Index Funds? 

The main risk is market risk, as index funds do not actively manage stocks to avoid downturns. Additionally, tracking error can impact performance slightly.

*Disclaimer: Terms and conditions apply. The information provided in this article is generic in nature and for informational purposes only. It is not an investment recommendation. Investments are subject to market risks and other risks.