Should you invest in index funds?

What are index funds?

Index funds are passive mutual fund schemes which track a market benchmark index e.g. Nifty 50, BSE Sensex, and Bank Nifty etc. Assets under management (AUM) of passive funds have seen explosive growth in India in the last few years, especially since the COVID-19 pandemic. Industry AUM of Exchange Traded Funds (ETFs) and index funds was nearly Rs 7 lakh crores (as on 30^th April 2023, source: AMFI) multiplying near 4 times in the last 3 years. Though index funds have traditionally been equity products, a large number of debt index funds have been launched in the last 2 years or so.

What is the difference between an active fund and an index fund?

Active funds are managed by fund managers who aim to beat the market benchmark index of the scheme. For example, if the benchmark index of an equity fund is Nifty 500 TRI, then the fund manager of the scheme will aim to generate returns higher than Nifty 500 TRI over a sufficiently long investment horizon e.g. 3 years. An index fund does not aim to beat the market benchmark index; they simply track the index. Since an index fund does not require active fund management, the Total Expense Ratio (TER) of an index fund is much lower than an active fund.

Should you invest in active fund or index fund?

The returns of an index fund will closely match the returns of the market benchmark index. An active fund on the other hand, aims to give higher returns than the market benchmark index and generate alphas for investors. Even though an active fund aims to give higher returns than an index fund, there are several benefits of an index fund which investors should consider when making investment decisions. They are as follows:-

• The TERs of index funds are much lower than active funds. This can be a significant advantage for investors in the long term. In order to outperform an index fund tracking the same market benchmark index, an active fund will have to beat the benchmark index by a margin higher than difference in TERs of the two funds. For example, if the TER of an index and an active fund is 0.1% and 2% respectively, then the active fund will have to beat the benchmark by more than 1.9% in order to outperform the index fund.


• Active funds need to be overweight / underweight on some stocks / sectors to beat the market benchmark index - this gives rise to unsystematic risk i.e. stock or sector specific risk. There is no unsystematic risk in index funds because they invest in the entire basket of stocks in the index they are tracking, in the same proportion as the market index. Index funds are only exposed to market risks.


• Index funds which track market cap weighted indices give higher weights to strong performers and lower weights to poor performers in their basket of securities because that is how market cap weighted indices work. Active funds may have concentration limits in their mandates i.e. they may not increase their weight in a particular security beyond a certain limit.

What are the differences between index funds and ETFs?

Investors have two options, as far as passive investing is concerned – ETFs and index funds. ETFs, like index funds, are passive schemes which track a market benchmark index. They are similar to index funds in terms of performance, though some ETFs may give higher returns than index funds due to lower TERs. ETFs are listed in stock exchanges and trade like shares of companies. You need to have Demat and trading accounts to invest in ETFs.

Should you invest in ETFs or index funds?

The TERs of ETFs are usually lower than TERs of index funds – lower TERs imply higher returns. Index funds usually have more cash in their portfolios to meet redemption requests. This may give rise to higher tracking error (difference between benchmark index returns and scheme returns). ETF transactions (buy / sell) take place on the basis ofcurrent market prices. You can take advantage of intraday price movement, by selling your ETF units at a higher price than the closing price. Index fund transactions, on the other hand, are based on the end of day Net Asset Value (NAV) of the scheme. These advantages for ETFs notwithstanding, there are several benefits of investing in index funds, which investors should consider:-

• You do not need Demat and trading account to invest in index funds.


• You can sell your ETF units only in the stock exchanges unless you are transacting in lot sizes as specified by the Asset Management Company (AMC). Liquidity might be a concern for some ETFs in extreme market conditions, as there may not be sufficient buyers in the markets.


• You can redeem your index fund units with the AMC. Liquidity is not a concern in index funds.


• ETF transactions in the stock exchange take place on the basis of market price (bid / ask prices). The market prices can be higher or lower than the NAV of the scheme depending on market conditions and liquidity.


• Index fund transactions take place on the basis of NAVs. If your redemption request is received before the cut-off time, you will get the NAV of the day for your index fund redemption. If your redemption request is received after the cut-off time, you will get the next day NAV.


• You can invest in index funds from your regular savings through Systematic Investment Plans (SIPs).

How to decide between ETFs and index funds?

If you do not have Demat and trading account, you can invest in index funds. As mentioned earlier, they are very similar to ETFs in many respects. If you have experience in buying and selling stocks in the market, then investing in ETFs will be easier for you. Index funds, on the other hand, are mutual funds; they have all the advantages associated with mutual funds e.g. convenience, flexibility, investing through SIP / STP etc. You should decide based on your investment needs and experience. You should consult with your mutual fund distributor or financial advisor and make informed investment decisions.

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