Index Funds

What are Index Funds?

Index funds are financial vehicles that mimic the behaviour of a selected market index, such as S&P BSE-100 or Nifty 50. In concept, they are similar to Exchange Traded Funds (ETFs) or Mutual Funds and are managed by a funds manager. Your portfolio would consist of stocks in the same proportion as the index the fund is attempting to mimic.

The underlying objective is to achieve proportionate performance from the fund as the selected market index is delivering in the market. You could say an Index Fund “tracks” the performance of the market index built on. Hence, they are also called “Index Tracking Funds.”

Who Should Invest in Index Funds?

Index mutual funds mimic market indices and aim to emulate the same performance as the index; the returns one can generate from index mutual funds thus are fraught with incumbent risks. If your investment objective matches any (or all) of the following points, then index mutual funds are for you.

You Don’t Intend to Buy/Sell Frequently.

Index mutual funds are a passively managed entity that does not involve much buying and selling, as they track a particular market index. If you seek to build a portfolio with fewer trade instances, then opting for index mutual funds would be the right choice.

You Want Better Portfolio Exposure

Index mutual funds invest your corpus in the stocks listed on an index for emulating it – the index could have 50 stocks or 500 stocks). This gives an opportunity of diversifying your investment portfolio by selecting a market index that features the industry stock you wish to include in your portfolio.

You Seek a Low-Cost Investment Option

Index mutual funds are also called “Low-Cost Funds” because your fund manager doesn’t actively have to decide your money. Less buying and selling is involved, and the portfolio composition also doesn’t change much over the investment period. This makes index mutual funds trade at lower costs than actively managed funds.

You Have Low Appetite for Risk

Index funds are typically low-risk funds because of the diversity of investment constituted in them. If you wish to invest in equities but with lesser risk, invest in index mutual funds.

Features of Index Funds

Before searching for potential index funds to invest in, it is important to be aware of the features of this fund. It can help you make an informed decision. Following are some salient features of index funds:

  • Index funds are highly diversified and designed for low-cost, proportionate investment in the same stocks that appear on the chosen market index.
  • A funds manager manages index funds. However, his only role is to select the stocks according to the underlying index to match the portfolio.
  • Returns from an index fund are more or less similar to the returns from the underlying market index; it is the primary objective of an index fund – to match the returns to the index it imitates.
  • Diversification does absorb some risk inherent in index funds. However, it largely depends on the volatility of the assets listed on the index that the fund is based on.

Taxability of Index Funds

The best index mutual funds generate decent returns for you depending on the performance of the basal market index. The gains you register from these funds are taxable in the following manner:

Capital Gains Tax

When you register capital gains from selling off your index fund stock, you become liable for capital gains tax on the profits thus earned. There are two tiers of capital gains tax:

  • Short term gains, where you held the stock for less than 12 months. CGT, in this case, is as follows:
    • For listed domestic shares, 15%.
    • It is as per the income tax slab rate for unlisted domestic shares held up to 24 months.
    • For foreign shares held up to 24 months, it is as per income tax slab rate.
  • Long term gains, where you held the stock for 24 months or above. The CGT, in this case, is as follows:
    • For listed shares held for more than 12 months, for long term capital gain exceeding ₹1 lakh in one FY, it is 10%.
    • For unlisted shares held for more than 24 months, it is 20% with indexation.
    • For foreign shares held for more than 24 months, it is 20% with indexation.

Risks Involved With Index Funds

No investment in the market is risk-free. An index fund mutual fund is designed to track the performance of a particular market index; it also translates into the fund inheriting the same risks as the selected index. Additionally, there are a few other risks involved with index fund mutual funds:

No Downhill Assistance

Since a market fund closely follows a particular market index, things go well while the index performs well. However, the moment this performance begins to fall, index fund mutual funds provide no mechanism to reel in the snowball. You may consider hedge funds to control your losses, but effectively there are not many other viable options.

Absence of Modification Mechanisms

Market indices may sometimes have stock that is overvalued/undervalued. Index funds are designed to be proportionate to the weight of stock on an index, thus leaving you with no option to reduce your portfolio exposure to that fund despite knowing its true value.

Loss of Strategy

Managing funds through a manager brings the benefit of a sound strategy to an actively managed fund. However, index fund mutual funds are passive – it makes you lose out on the benefits of having an investment strategy in place for better gains.

Advantages of Index Mutual Funds

Despite index funds being a passive, static mode of investment, there are several upsides to investing in top index mutual funds:

  • The low-fee/low-cost model makes top index mutual funds a good option for many first-time investors since there is no decision-making involved.
  • Top index funds are like a package deal with automated investment packets that follow market indices. As such, index funds are free from human biases, favours, or disfavors, making them objective vehicles for investment.
    • Top index funds let the investor enjoy a vast portfolio with a single fund. For example, investing in the Nippon India Index Fund – Nifty Plan-Growth allows you to diversify your portfolio across 10+ industry sectors through 50 highly regarded stocks in the market.
  • Top index funds involve very little management – on your part and the fund manager’s – allowing them to be managed easily. Apart from periodically rebalancing your portfolio, there is little else that needs to be done.
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