How to Invest in Index Funds in India

Index funds offer a straightforward approach to participating in market growth by mirroring specific market benchmarks. These funds are gaining attention in India, providing retail investors with a way to align their portfolios with the broader economy. Investing in index funds can be appealing for individuals seeking diversified exposure without the complexities of active stock picking.

Understanding and Selecting Index Funds in India

Index funds in India are mutual fund schemes designed to replicate the performance of a particular market index, such as the Nifty 50 or Sensex. These funds maintain a portfolio of stocks in the same proportion as their chosen benchmark, aiming to deliver returns comparable to the index. Unlike actively managed funds, index funds do not attempt to outperform the market; instead, they strive to match its movements as closely as possible.

A distinction exists between index mutual funds and Exchange Traded Funds (ETFs) in India, though both pursue the objective of mirroring an index. Index mutual funds are bought and sold at the end-of-day Net Asset Value (NAV), similar to traditional mutual funds. ETFs, conversely, trade on stock exchanges throughout the day, much like individual stocks, with their prices fluctuating in real-time.

India features several key indices that serve as benchmarks for these funds, with the Nifty 50 and Sensex being the most prominent. The Nifty 50 comprises 50 large and liquid companies listed on the National Stock Exchange (NSE), representing a broad cross-section of the Indian economy. The Sensex includes 30 large companies listed on the Bombay Stock Exchange (BSE), acting as a barometer of market sentiment. Beyond these broad market indices, sectoral and thematic indices like Nifty Bank or Nifty IT track specific industries, allowing for more targeted investments.

When selecting an index fund in India, several factors warrant consideration. The expense ratio, the annual fee charged by the fund house, is an important metric; a lower expense ratio is preferred as it directly impacts net returns. Tracking error measures how closely the fund’s returns align with its underlying index; a lower tracking error indicates better replication. The fund’s Assets Under Management (AUM) offers insight into its liquidity and investor confidence, with higher AUM often suggesting broader acceptance. Choosing an index fund from a reputable Asset Management Company (AMC) can provide assurance regarding fund management and regulatory compliance.

Prerequisites for Investing

Before investing in index funds in India, individuals must establish specific accounts and complete regulatory compliance procedures. A Dematerialized (Demat) account is a requirement, serving as a digital repository to hold securities like shares, bonds, mutual funds, and ETFs. This account eliminates the need for physical share certificates, enhancing security and streamlining transactions.

A trading account works with the Demat account, enabling investors to place buy and sell orders on stock exchanges. While the Demat account stores securities, the trading account facilitates transactions. Many financial institutions offer integrated 2-in-1 or 3-in-1 accounts that combine banking, Demat, and trading functionalities for seamless operations.

Know Your Customer (KYC) compliance is mandatory for all financial transactions in India, verifying the investor’s identity and address to prevent illicit activities. The KYC process requires submission of officially valid documents. These include a PAN (Permanent Account Number) card, Aadhaar card, passport, voter ID, or driving license for identity proof. For address verification, documents like utility bills (not older than one month), bank statements, or a rental agreement are accepted.

Linking a bank account to the Demat and trading accounts is necessary for efficient fund transfers. This linked bank account facilitates debiting funds for purchases and crediting proceeds from sales or dividends. The entire account opening and KYC verification process can be completed online, with digital submissions and Aadhaar-based e-KYC options expediting setup.

The Investment Process

Once accounts are established and KYC compliance is complete, investors can purchase index funds. The initial step involves selecting an investment platform, such as online brokerage platforms, direct Asset Management Company (AMC) websites, or mutual fund aggregators. These platforms provide the interface for searching, selecting, and transacting in index funds.

For investing in index mutual funds, the process generally involves logging into the chosen platform, navigating to the mutual fund section, and searching for the desired index fund by name. Investors then specify the investment amount and choose between a Systematic Investment Plan (SIP) or a lump sum investment. A SIP involves investing a fixed amount at regular intervals, fostering disciplined investing and benefiting from rupee-cost averaging. Conversely, a lump sum investment is a one-time, larger allocation. After selecting the investment type, the transaction is confirmed, and payment can be made through various methods like net banking or Unified Payments Interface (UPI).

Investing in Index Exchange Traded Funds (ETFs) follows a procedure similar to trading individual stocks, requiring a trading account. Investors log in to their trading platform and search for the ETF using its ticker symbol. They then specify the quantity of units to buy and choose an order type, such as a market order (to buy at the current market price) or a limit order (to buy at a specified price or better). ETFs offer the flexibility of being traded throughout market hours, allowing for real-time price execution. Upon successful order placement and payment, ETF units are credited to the investor’s Demat account, and a confirmation is provided.

Taxation of Index Fund Investments

Taxation of index fund investments in India primarily revolves around capital gains and dividends. When units of an index fund are sold, any profit realized is categorized as a capital gain. The tax treatment of these gains depends on the investment’s holding period and whether the fund is equity-oriented or debt-oriented.

For equity-oriented index funds, which primarily invest in Indian stocks, gains from units held for less than 12 months are considered Short-Term Capital Gains (STCG). These STCGs are taxed at a rate of 20%, plus applicable surcharge and cess.

Long-Term Capital Gains (LTCG) arise when equity-oriented index fund units are held for over 12 months. As per recent budget changes, LTCG up to ₹1.25 lakh in a financial year are exempt from tax. Any LTCG exceeding this ₹1.25 lakh threshold are taxed at a rate of 12.5%, along with applicable surcharge and cess. This tax is applied without indexation benefit for equity-oriented funds.

Dividends distributed by index funds are taxable in the hands of the investor. This income is added to the investor’s total income and taxed according to their applicable income tax slab rate. If the dividend income exceeds ₹5,000 in a financial year, a Tax Deducted at Source (TDS) of 10% is applicable. For debt index funds, which invest predominantly in fixed-income instruments, all gains, regardless of holding period, are added to the investor’s taxable income and taxed at their income slab rate. The indexation benefit, which adjusts the purchase price for inflation, is not available for debt index funds for investments made after April 1, 2023.