Diversification is a key element of a good investment portfolio. Investors try to spread their funds across various asset classes like equity, debt, real estate, gold, etc. Even within each asset class, they try to further diversify to minimize risks. In equity investing, a known method of reducing risks is diversifying your equity portfolio by investing in shares of companies from different sectors and of market capitalizations. This is where the Index Funds step in. Here, we will explore Index Funds and talk about the different types of index funds in India along with their benefits and a lot more.
What are Index Funds?
As the name suggests, an Index Mutual Fund invests in stocks that imitate a stock market index like the NSE Nifty, BSE Sensex, etc. These are passively managed funds which means that the fund manager invests in the same securities as present in the underlying index in the same proportion and doesn’t change the portfolio composition. These funds endeavor to offer returns comparable to the index that they track.
How do Index Funds work?
Let’s say that an Index Fund is tracking the NSE Nifty Index. This fund will, therefore, have 50 stocks in its portfolio in similar proportions. An index can include equity and equity-related instruments along with bonds. The index fund ensures that it invests in all the securities that the index tracks.
While an actively managed mutual fund endeavors to outperform its underlying benchmark, an index fund, being passively managed, tries to match the returns offered by the underlying index.
Who should invest in an Index Fund?
Since Index Funds track a market index, the returns are approximately similar to those offered by the index. Hence, investors who prefer predictable returns and want to invest in the equity markets without taking a lot of risks prefer these funds. In an actively managed fund, the fund manager changes the composition of the portfolio based on his assessment of the possible performance of the underlying securities. This adds an element of risk to the portfolio. Since index funds are passively managed, such risks do not arise. However, the returns will not be far greater than those offered by the index. For investors seeking higher returns, actively managed equity funds are a better option.
Factors to consider before investing in Index Funds in India
Here are some important aspects that you must consider before investing in index funds in India:
Risks and Returns
Since index funds track a market index and are passively managed, they are less volatile than the actively managed equity funds. Hence, the risks are lower. During a market rally, index funds returns are good usually. However, it is usually recommended to switch your investments to actively managed equity funds during a market slump. Ideally, you should have a healthy mix of index funds and actively managed funds in your equity portfolio. Further, since the index funds endeavor to replicate the performance of the index, returns are similar to those of the index. However, one component that needs your attention is Tracking Error. Therefore, before investing in an index fund, you must look for one with the lowest tracking error.
Expense Ratio is a small percentage of the total assets of the fund charged by the fund house towards fund management services. One of the biggest USP of an index fund is its low expense ratio. Since the fund is passively managed, there is no need to create an investment strategy or research and find stocks for investing. This brings the fund management costs down leading to a lower expense ratio.
Invest according to your Investment Plan
Index funds are recommended to investors with an investment horizon of 7 years or more. It has been observed that these funds experience fluctuations in the short-term but it averages out over a longer term. With an investment window of at least seven years, you can expect to earn returns in the range of 10-12%. You can align your long-term investment goals with these investments and stay invested for as long as you can.
Being equity funds, index funds are subject to dividend distribution tax and capital gains tax subject to dividend distribution tax and capital gains tax.
Dividend Distribution Tax (DDT)
When a fund house pays dividends, a DDT of 10% is deducted at source before making the payment.
Capital Gains Tax
On redeeming the units of an index fund, you earn capital gains – which are taxable. The rate of tax depends on the holding period – the period for which you were invested in the fund.
- The capital gains earned by you for a holding period of up to one year = Short Term Capital Gain (STCG) which is taxed at 15%.
- The capital gains earned by you for a holding period of more than one year = Long Term Capital Gain (LTCG). LTCG up to Rs. 1 lakh is not taxable. Any LTCG above this amount is taxed at the rate of 10% without indexation benefits.