SIP in Index Funds: Meaning, Benefits And Reasons To Invest

Building long-term potential wealth is often associated with following a disciplined investment process rather than reacting to frequent market movements. In this context, retail investors may consider index funds combined with a Systematic Investment Plan (SIP) as one possible approach.

An index fund SIP brings together rule-based index tracking and the behavioural aspects of regular, periodic investing.

This article explains what index funds are, how SIPs work within them, their potential benefits, key considerations, and how investors may assess whether this approach aligns with their financial goals.

Table of contents

• What are index funds?
• What is SIP in index funds?
• How to start SIP in index funds?
• Why choose an index fund SIP?
• Benefits of starting an SIP in an index fund
• Potential disadvantages of SIPs in index funds
• How to select suitable funds?
• Factors to consider before starting an SIP in index funds

What are index funds?

Index funds are a category of mutual funds designed to track the performance of a specific market index. They aim to replicate the composition of the underlying index by investing in the same securities in substantially similar weights as those included in the index.

SEBI (Securities and Exchange Board of India) classifies index funds as passively managed mutual fund schemes, where the primary objective is to track the benchmark index rather than attempt to potentially outperform it. Common examples include broad market indices such as the Nifty 50 or BSE Sensex, sectoral indices such as the Nifty PSU Bank index, and other thematic indices.

Due to their rule-based structure, index funds typically involve relatively lower portfolio churn compared to actively managed funds. This approach may allow investors to participate in the performance of a chosen benchmark with relatively lower monitoring requirements, though periodic review remains important.

What is SIP in index funds?

A Systematic Investment Plan allows investors to invest a fixed amount at regular intervals (such as weekly, monthly, quarterly, etc.) into a selected index fund. When these two elements are combined, investors may potentially benefit from the following characteristics:

• An SIP may introduce discipline by enabling regular and consistent investing over time.
• Index funds provide exposure to a broad market, sector, or theme by tracking a chosen benchmark index.

This method spreads investments across different market levels over time, which may help average the purchase cost of units. For long-term investing, such as periods extending beyond five years, this approach may result in a relatively less volatile experience compared to making a single lumpsum investment, though market risks continue to apply. Investors must note, however, that while SIPs may help spread investments across market levels, they do not prevent short-term declines in portfolio value during prolonged or sharp market downturns.

Also Read: Large cap funds vs. index funds: Which is more suitable?

How to start SIP in index funds?

Starting an index fund SIP generally involves the following steps, though specific procedures may vary across different fund houses and platforms:

• Complete KYC: Investors must comply with Know Your Customer requirements, including identity and address verification.
• Choose the index fund category: Investors may select an index fund based on the benchmark they wish to track, taking into account personal financial goals, investment horizon, and risk appetite. No scheme-specific recommendations are implied.
• Select SIP amount and frequency: Investors may choose an SIP amount and contribution frequency as per the scheme’s minimum requirements.
• Set up the mandate: A bank mandate enables automatic deduction of the SIP amount at the chosen frequency.
• Monitor periodically: While index funds are passively managed, periodic review may help ensure alignment with evolving financial plans.

Each index fund SIP is subject to market risks, and unit allocation depends on the applicable NAV (Net Asset Value) on the transaction date.

Why choose an index fund SIP?

An index fund SIP offers investors a relatively transparent and rule-based approach to investing (though this does not guarantee returns). Since the fund tracks a predefined index, investment decisions are guided by index construction rules rather than active stock selection. At the same time, SIPs may help investors remain invested without reacting emotionally to short-term market movements. As a result, this approach might commonly be considered by retail investors seeking market-linked exposure through a systematic contribution method.

Benefits of starting an SIP in an index fund

• Diversification: Index funds invest across multiple securities included in a chosen index, which may help diversify potential risks across companies and sectors. While index funds do not eliminate market risk, diversification may reduce the impact of any single security on the overall portfolio’s potential returns.
• Cost-efficiency: Index funds generally operate with relatively lower expense ratios compared to actively managed mutual funds, as they follow a passive investment approach. Fund managers track the benchmark and manage operational processes, which may result in relatively lower portfolio turnover and related costs. Expenses are adjusted before the NAV is declared. Lower costs do not guarantee higher potential returns but may support a cost-conscious investment structure over time.
• Objective investment approach: Index funds follow predefined rules to track their benchmark, which may reduce reliance on discretionary stock selection. Fund performance is designed to mirror the index, subject to tracking error. SIPs might further support this by helping enable periodic investments without the need for frequent timing decisions.

Potential disadvantages of SIPs in index funds

• Market-linked risk remains: Index fund SIPs remain fully exposed to market movements, as the underlying fund tracks a benchmark index. In periods of market decline, the value of investments may fall in line with the broader market, regardless of the SIP structure.
• No downside protection in falling markets: An SIP does not provide protection against sustained market downturns. While periodic investing may help average purchase costs over time, it does not prevent losses during prolonged or sharp declines in market indices.
• Not designed to outperform the market: Index funds are designed to replicate benchmark performance rather than generate returns above the index.
• Tracking error risk: Index funds may not perfectly replicate the performance of their benchmark index due to factors such as expenses, cash holdings, rebalancing timelines, or operational constraints. As a result, actual returns may differ from index returns over time.
• Index-related limitations: Index funds are designed to replicate benchmark performance rather than outperform it. As a result, investors may experience underperformance during periods when the index itself delivers weak or negative returns.

How to select suitable funds?

When evaluating index funds for SIP investments, investors may consider the following aspects:

• Benchmark index: Understanding what the benchmark represents is important. Broader indices track a wider segment of the market, while sectoral or thematic indices usually have a narrower focus on specific industries or themes.
• Tracking error and tracking difference: These measures indicate how closely the fund follows its benchmark. Lower tracking deviations may reflect closer alignment with the index.
• Expense ratio: Lower expense ratios mean more of the potential returns stay with the investor, which can make a significant difference in the long term.
• Fund management process: Even passive funds may require operational efficiency to manage rebalancing, inflows, outflows, and corporate actions.
• Investor’s financial plan: Assessing investment horizon, liquidity needs, and risk appetite is advised before selecting any index fund.

Investors may consider consulting a financial adviser to gauge potential suitability.

Also Read: Index Funds vs Flexi Cap Funds: How are they different?

Factors to consider before starting an SIP in index funds

Starting an SIP in an index fund depends on individual preferences, financial goals, and risk tolerance. Index funds are market-linked products and reflect overall market movements. An SIP may help spread investments over time, which may reduce the impact of short-term volatility, though it does not eliminate risk.

Some key considerations may be:

• Time horizon: Index fund SIPs in equity funds may be suitable for investors with longer investment horizons, as short-term market movements may be unpredictable. Past performance may or may not be sustained in the future.
• Risk tolerance: Since index funds invest predominantly in equities, they are classified as potentially high risk and require a corresponding risk appetite.
• Financial goals: Index fund SIPs may align with long-term objectives such as retirement planning, education-related goals, or potential wealth creation over time.
• Cost sensitivity: Passively managed funds may appeal to investors who are conscious of relatively lower costs compared to actively managed funds.

Conclusion

An index fund SIP may offer a relatively transparent and disciplined method for participating in financial markets over the long-term. Combining index tracking with periodic investing may support a structured approach to investing. However, index funds remain subject to market risks and do not provide assured outcomes. Investors may consider consulting a SEBI-registered financial adviser to gauge potential suitability. Investment decisions should be based on individual financial circumstances, goals, and risk tolerance.

FAQs

What is the average return on a SIP index fund?

Potential returns vary based on the underlying benchmark index and prevailing market conditions. Index funds aim to track index performance, but actual outcomes depend on tracking error and the investment period. Past performance may or may not be sustained in the future.

Is it good to do SIP in index funds?

An index fund SIP may be suitable for investors seeking a disciplined, rule-based investment approach with market-linked exposure. Potential suitability depends on individual goals, time horizon, and risk tolerance.

What is the minimum SIP for an index fund?

The minimum SIP amount varies for different mutual fund schemes. Many index funds allow relatively modest starting amounts, which may improve accessibility for retail investors.

How do I choose an SIP index fund?

Investors may consider factors such as the benchmark index, expense ratio, tracking error, investment horizon, and alignment with personal financial goals.

Can we do an SIP in an index fund?

Yes. Investors may set up periodic contributions and accumulate units over time based on the fund’s applicable NAV.