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An index fund is a mutual fund that imitates the portfolio of an index. These funds are also known as index-tied or index-tracked mutual funds. Let us explore index funds in detail through the following topics.
1. What is an Index Fund?
Many investors are aware of the benefits of diversifying their portfolio across assets. Index funds often catch their eyes in this search as they refer to funds that invest in a broader market index – like the Sensex or the Nifty. Index funds are not actively managed funds, thus incurs low expenses. They do not aim at outperforming the market, but instead to maintain uniformity. They help an investor manage or balance risks in investment portfolio.
2. How do Index Funds Work?
When an index fund tracks a benchmark like the Nifty, its portfolio will have the 50 stocks that comprise Nifty, in the same proportions. An index is a group of securities defining a market segment. These securities can be bond market instruments or equity-oriented instruments like stocks. Since index funds track a particular index, they fall under passive fund management.
While an actively-managed fund strives to beat its benchmark, an index fund’s role is to match its performance to that of its index. Index funds typically deliver returns more or less equal to the benchmark. However, there can be a small difference between fund performance and the index. This is referred to as the tracking error. The fund manager must work towards bringing down the tracking error as much as possible.
3. Who should invest in Index Funds?
The investment decision in a mutual fund solely depends upon your risk preferences and investment goals. Index funds are ideal for investors who are risk-averse and expect predictable returns. These funds will give you returns matching the upside that the particular index sees. The returns of index funds may match the returns of actively-managed funds in the short run.
4. Things to Consider as an Investor
Risk tolerance
Since index funds map an index, they are less prone to equity-related volatility and risks. Investing in index funds is an excellent option if you wish to generate high returns amid a rallying market. However, you will have to switch to actively-managed funds during a market slump. Index funds tend to lose their value during a market downturn. Hence, it is advised to have a mix of actively-managed funds and index funds in your portfolio.
Return factor
Unlike actively-managed funds, index funds track the performance of the underlying benchmark passively. These funds do not aim to beat the benchmark but just to replicate the performance of the index. However, the returns generated may not be at par with that of the index due to tracking errors. There can be deviations from actual index returns.
Hence, it is advised to shortlist funds with minimum tracking error before investing in an index fund. The lower the errors, the better the performance of the fund.
Cost of investment
Index funds usually have an expense ratio of 0.5% or even less. If two index funds are tracking the Nifty, both will generate similar returns. The only difference will be the expense ratio. The fund, which has a lower expense ratio, will generate comparatively higher returns on investment.
Investment horizon
Index funds, generally, suits individuals with a long-term investment horizon. Usually, the fund experiences many fluctuations during the short-run, which averages out in the long-run, say, more than seven years to generate returns in the range of 10%-12%. Those who choose index funds must be patient enough to stick around for at least that long. Only then can the fund perform at its full potential.
Financial goals
Equity funds can be ideal for achieving long-term financial goals like wealth creation or retirement planning. Being a high risk-high return haven, these funds are capable of generating enough wealth, which may help you retire early and pursue your passion in life.
Tax on gains
When you redeem units of index funds, you earn capital gains, which are taxable. The rate of taxation depends on how long you stayed invested in index funds, i.e., the holding period.
Capital gains you make during the holding period of up to one year are called short-term capital gains (STCG). STCG is taxed at a rate of 15%. Similarly, capital gains you earn after a holding period of more than one year are called long-term capital gains (LTCG). LTCG over Rs 1 lakh is taxed at 10% without the benefit of indexation.
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