A Primer on Broad-Market Index Funds

Index investing, or passive investing, has grown rapidly in India’s mutual fund industry over the last few years. Not only more investors than before are choosing this option to put their money to work but they are also increasing the amount allocated to index funds compared to actively managed mutual funds.

This trend has prompted mutual fund companies to launch more passive investing schemes to attract investors. In turn, this has led financial planners, personal finance advisors, and even social media influencers to point out the advantages and disadvantages of index funds.

But if you have ever read a newspaper column, a blog or a LinkedIn post advising you to invest in an index fund and still feel unsure because of all the jargon, worry not. Here is a quick read that can help you leverage the power of passive investing and build wealth for yourself in the long term.


What are index funds?


First things first, let’s get the jargon out of the way.

An index fund is essentially a type of mutual fund that matches or tracks a capital market index.

But that doesn’t really cut it, does it? So, let’s take a step back.

A capital market index refers to a collection of stocks, bonds, commodities, or a mix of these, grouped together based on certain parameters to measure their price movements. These parameters can be market capitalisation or the type of securities (equity, debt, gold etc); type of sectors (auto, banking and so on); and investment themes or strategies.

Of these various types, broad-market indices based on market capitalisation of stocks are the most widely tracked. As a result, mutual fund index funds that track these indices are the most popular among investors.

Since each of these funds track a particular index, their returns – in theory – should be the same as the returns offered by the respective index. However, in practice, their returns are slightly lower than that of the index. This is because of two factors—expense fees and tracking error.

The expense fee is a nominal amount deducted by the mutual fund company for managing the fund and for other administrative costs incurred. However, this fee is quite low compared to actively managed funds, where the fund managers, as per their experience and expertise, decide how your funds are allocated.

For instance, while large-cap index funds charge an expense fee (Total Expense Ratio, or TER) of around 0.20%, the fee for actively managed large-cap index funds can go as high as 1% and above.

The tracking error indicates how closely a fund tracks its benchmark index. In other words, it shows the difference in returns of the underlying index and the index fund. This error is typically less than 2%. A lower error is always better.


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Broad-market indices and index funds


Broad-market indices consist of the largest and most liquid stocks listed on a stock exchange. These indices act as a benchmark to measure the performance of the stocks or mutual fund portfolios.

These indices, and their related index funds, are created on the basis of free-float market capitalisation of stocks.

Free-float refers to shares that can be publicly traded. Free-float market capitalisation is the value of shares that can be publicly traded multiplied by the total number of shares.

The broad-market indices and index funds can be broadly divided into large-caps, mid-caps, small-caps, or a combination of any of the two, or all of the above.

Going by this classification, the indices on the National Stock Exchange include the Nifty 50, Nifty Next 50, Nifty 100, Nifty 200, Nifty Midcap 150, Nifty Midcap 100, Nifty Smallcap 250, and even Nifty 500. The BSE have similar indices, such as the 30-stock Sensex, BSE 100, BSE 500 and so on.


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Large-cap index funds


According to the classification devised by the market regulator Securities and Exchange Board of India, the 100 largest companies by market capitalisation are called large-cap companies.

Large-cap companies are less volatile than mid or small-cap companies and deliver relatively more consistence returns in the long run. These companies are often the first to recover in the aftermath of a recession or a market crash as they have long business legacies and credible reputations.

Large-cap index funds are ideal for investors looking to minimise risk and those who don’t mind the fact that such funds might not deliver stellar returns like mid and small-cap schemes.

The BSE Sensex, BSE 100, the Nifty 50, the Nifty Next 50 and the Nifty 100 are all large-cap indices, and index funds that track these indices are large-cap index funds.


Sensex and Nifty 50 index funds


The Nifty 50 comprises India’s top 50 companies as per their free-float market capitalisation on the National Stock Exchange while the Sensex groups the 30 largest companies on the BSE.

Now, a Nifty 50 index fund — as its name suggests — invests in the Nifty 50 index, in the same ratio as the index itself. The same goes for the Sensex fund.

As the Nifty 50 index stands currently, HDFC Bank is the largest constituent on the index by weight (11.07%), followed by Reliance Industries (10.22%) and ICICI Bank (7.80%).

This means that the index fund takes your SIP or lumpsum contribution and invests it as per the company weightage on that index. So, if you have a monthly SIP of Rs 5,000 in a Nifty 50 index fund, Rs 553.5 will go towards HDFC Bank (Rs 5,000*11.07%), Rs 511 will be invested into Reliance and Rs 390 will be invested into ICICI Bank and so on.


 Fund name  AUM (₹ Cr.) as on 18 Apr 24  TER (%)
 UTI Nifty 50 Index Fund  16,199  0.21
 HDFC Index Fund- Nifty 50 Plan  12,764  0.20
 ICICI Prudential Nifty 50 Index Fund  6,955  0.19
 SBI Nifty Index Fund  6,850  0.18
 HDFC Index Fund – S&P BSE Sensex Plan  6,620  0.20


Nifty Next 50 index


The Nifty Next 50 index includes the companies after the Nifty 50 stocks as per the free-float market capitalisation. If these companies progress and become bigger, they will be included in the Nifty 50.

This index is relatively riskier and more volatile than the Nifty 50 index. On the flip side, it also holds the potential to deliver higher returns than the Sensex or the Nifty 50 index.

After the Sensex and Nifty 50 funds, the Nifty Next 50 is the most popular index fund category.

While this is a large-cap index, it is also recommended as an alternative to mid-cap funds because many of its constituents exhibit similar traits as high-growth mid-cap stocks.


 Fund name  AUM (₹ Cr.) as on 18 Apr 24  TER (%)
 ICICI Prudential Nifty Next 50 Index Fund  4,444  0.30
 UTI Nifty Next 50 Index Fund   3,529  0.35
 SBI Nifty Next 50 Index Fund   745  0.34
 HDFC NIFTY Next 50 Index Fund  530  0.30
 DSP Nifty Next 50 Index Fund  468  0.30



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Mid-cap index funds


Going by the previously mentioned categorisation, companies ranking from number 101 to 250 in the Nifty 500 of BSE 500 universe are called mid-cap companies. Mid-cap index funds invest in the companies falling in this category.

Mid-cap index funds can either invest in the first 100 companies, that is, companies ranked from 101 to 200 or they can also invest in all 150 companies, that is, from companies ranked number 101 to company 250.

By browsing through the mutual fund details and the benchmark it follows, investors will be able to find out if the said mid-cap index fund invests in Nifty Mid cap 100 or Nifty Mid-cap 150.

Mid-cap companies deliver stronger returns than large-cap companies but their returns tend to swing wildly. They are suitable for investors who are looking to grow their funds aggressively. These companies stand out during market booms but can crash badly during recessions or market meltdowns.


 Fund name   AUM (₹ Cr.) as on 18 Apr 24  TER (%)
 Motilal Oswal Nifty Midcap 150 Index Fund  1,404  0.30
 Nippon India Nifty Midcap 150 Index Fund  1,163  0.30
 ICICI Prudential Nifty Midcap 150 Index Fund  358  0.28
 SBI Nifty Midcap 150 Index Fund  346  0.41
 Aditya Birla Sun Life Nifty Midcap 150 Index Fund  169  0.44



Small-cap index funds


Taking forward the same broader classification method, the companies ranking from 251 to 500 in the Nifty 500 or BSE 500 universe are small-cap companies. Small-cap index funds invest in these companies.

Small-cap index funds can either invest in the Nifty Small-cap 250, Nifty Small-cap 100 or the Nifty Small-cap 50. Browsing through the mutual fund material or looking up the benchmark the fund follows will tell the investor about the exact index tracked by the fund.

Small-cap funds are suitable for young investors with large risk appetites who place greater emphasis on rapid capital growth. These companies tend to deliver better returns than mid-cap companies. However, their returns can be extremely volatile. Investing in small-cap funds is recommended only for investors with high-risk tolerance.


 Fund name   AUM (₹ Cr.) as on 18 Apr 24  TER (%)
 Nippon India Nifty Smallcap 250 Index Fund  1,093  0.32
 SBI Nifty Smallcap 250 Index Fund  604  0.41
 Motilal Oswal Nifty Smallcap 250 Index Fund  589  0.36
 ICICI Prudential Nifty Smallcap 250 Index Fund  245  0.30
 HDFC Nifty Smallcap 250 Index Fund  137  0.30


Summing up


In addition to the large, mid and small-cap index funds, mutual fund companies also offer a few other alternatives. These include index funds that track the Nifty Total Market Index, or the BSE 500, or those that track the Nifty Large and Midcap 250 Index.

Before choosing an index fund, you must first decide your asset allocation and assess your risk appetite. You must also check and compare the expense fee and the tracking error of the index funds.

But whichever index fund you choose, make sure you invest regularly and stay invested for the long term. After all, as the saying goes, Rome wasn’t built in a day!


Cover image courtesy: https://storyset.com/people People illustrations by Storyset


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