All you need to know about index funds and how to invest in them.
Mutual Funds are of various types, allowing you to fulfil your different investment objectives per your risk appetite. A rule of thumb that many investors follow is diversifying their portfolios to minimise risks. One of the best mechanisms for risk minimisation is an index fund, a type of equity fund. Let us find out more about Index funds – their properties, factors, and who should invest in them.
An index fund is a type of equity fund that mimics the stock market indices, the NSE Nifty or the BSE Sensex. Unlike other funds where the fund manager actively and strategically invests in securities, in index funds, the fund manager buys and sells stocks according to the composition of the underlying benchmark of the indices. Since an index fund is passively managed, it generates lower expense ratios.
You might find yourself asking the question, 'If Index Fund mimics the Stock market, why invest in Index Funds and not the Stock Market?' To put it in simple words, when you invest in stocks of an individual company, you become a shareholder or part-owner in that company. You share the profit as well as the losses.
Assuming you invest in an Index Fund that tracks Nifty 50, the fund manager invests in the same 50 stocks trading on the NSE Nifty in the same proportion. Here, even if few companies perform poorly, there will be companies that will perform well. This leaves you with an average chance to earn returns with careful risk mitigation, which is always preferable to incurring losses by investing in just one company.
The nature of equity funds is dynamic and volatile. Hence, it involves a high-risk factor. However, index funds track an index and are less likely to face such risks. During a market slump, there are possibilities that the equity funds could lose their value. Therefore, it is advisable to have a good mix of index funds and actively managed funds.
Generally, the returns you earn typically mirror the returns of the underlying indices being mimicked. However, you should be aware of the term 'Tracking Error'. It is the difference between the return on the index fund and the return on the stock market index. For example, if the index mutual fund gives you a return of 5 per cent and Nifty gives you a return of 7per cent the Tracking Error here would be 2 per cent. In theory, to make the most out of index funds, the Tracking Error should be zero, but it typically has a 1- 2 per cent range.
Since index funds mimic an existing stock index, they are known as passively managed mutual funds, in that the fund manager does not have to choose stocks and create a unique portfolio carefully. Due to this passive management, the expense ratio is relatively low compared to what is charged on actively managed funds. A lower expense ratio means more savings in the investors' pockets, and the excellent performance of the funds also translates to higher returns.
Index Fund is a type of Equity Fund and is thus taxed similarly to equity funds. The rate of taxation depends on the holding period. Short-term capital gains (redeemed within a holding period of one year) attract 15 per cent tax. Long term Capital gains (redeemed after a holding period of one year) up to INR 1,00,000 is tax-exempted. Any gains above INR 1 Lakh will attract a 10 per cent tax.
Index funds perform better if held for longer durations, i.e., minimum of 5 to 10 years. This makes it an ideal investment for those looking for corpus creation or lump sum funds for retirement. Due to its substantially low-risk nature, investors who are sceptics of the stock market or actively managed equity funds can invest in Index Funds, too.
Index funds are perhaps a unique type of mutual fund investment. They are what one may call safe equity investments. These funds mirror a stock index with the best-performing companies while attempting to replicate their returns. These attributes make index funds a low-risk investment that offers higher returns, primarily when held for longer durations.
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*Disclaimer: This article is for information purposes only. We recommend you get in touch with your income tax advisor or CA for expert advice.