Index fund

What is an Index Fund?

An index fund is part of mutual fund that pools money from investors and invests it in securities such as stocks or bonds. An index fund aims to track the returns of a designated stock market index. A market index is a hypothetical portfolio of securities that represents a segment of the market

How do Index Funds work?

An index is a group of securities that define a particular market segment. Since index funds track a specific index, they fall under passive fund management. Under passively fund management, the securities traded are dependent on the underlying benchmark. Additionally, passively managed funds do not require a dedicated team of research analysts to identify opportunities and pick the most-suited stock.

Contrary to an actively managed fund that strives increasingly to time and beat the market, an index fund is designed to match the performance of its index. Thus, index funds returns are aligned to their underlying market index.

The returns are more or less equal to the benchmark, except a small difference known as tracking error. The fund manager often tries to dial down this error as much as possible.

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Advantages of investing in index funds

Following are some of the advantages enjoyed by index funds:

1. Low fees

Since an index fund mimics its underlying benchmark, there is no need for an efficient team of research analysts to help fund managers pick the right stocks. Also, there is no active trading of stocks. All these factors lead to low managing cost of an index fund.

2. No bias investing

Index funds follow an automated, regulation-based investment method. The fund manager is provided with a defined mandate of the amount to be invested in index funds of various securities. This eliminates human discretion/bias while taking investment decisions.

3. Broad market exposure

Investing money in a proportion similar to that of an index ensures that the portfolio is diversified across all sectors and stocks. Thus, an investor can seize the probable returns on the larger segment of the market through a single index fund. For instance, if you decide to invest in the Nifty index fund, you enjoy investment exposure to 50 stocks spread across 13 sectors, ranging from pharma to financial services.

4. Tax Benefits of Investing in Index Funds

Since index funds are passively managed, they usually enjoy low turnover, i.e. few trades placed by a fund manager in a given year. Fewer trades results in fewer capital gains distributions that are passed to the unitholders.

5. Easier to manage

Since fund managers do not have to worry themselves with how stocks on the index are performing in the market, index funds are easier to manage. A fund manager just needs to rebalance the portfolio periodically.

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Things to keep in mind while choosing index fund

Which index funds to invest in and why? | Arthgyaan

Who should invest in Index Funds?

You should invest in mutual fund according to your investment horizon, goals, and risk appetite. Index mutual funds are ideal for those investors who are risk-averse. Such funds do not require extensive research and tracking. For instance, if you want to invest in equities but do not want to expose yourself to the risks associated with actively managed equity funds, you can opt for a Nifty or Sensex index fund.

Things you should consider as an investor?

You should consider the following features of index funds before you decide to invest in them:

1. Index Fund Returns

Index funds aim to replicate the performance of their market index. Unlike actively managed funds, they do not try to beat the benchmark. However, the returns generated may not always be at par with that of their underlying index owing to tracking errors. The lower the errors, the better the index fund will perform.

2. Risk tolerance

Since index funds map a particular market index, they are less prone to equity-linked risks and volatilities. It’s a good idea to invest in index funds to generate optimal returns amid a rallying market. However, things could get ugly during a market downturn as index funds tend to lose their value during a slump. Hence, it is always advised to have a mix of actively and passively managed index funds in your portfolio.

3. Cost of investment

The expense ratio of index funds is usually 0 less, as compared to actively managed funds This is because the fund manager is not required to formulate any investing strategy for index funds. However, it should be noted that even a fund with a lower expense ratio has the potential to generate higher returns on investment.

4. Taxation#

You earn capital gains, which is taxable, upon redeeming the units of your index fund investment. The rate of taxation depends on your holding period, i.e. how long you stay invested. Short-term capital gains (STCG) or gains earned with a holding period of up to 1 year are taxed at 15% (plus surcharge as applicable plus 4% Health & education cess). Long term capital gains (LTCG) from funds held for more than 12 months attract long-term capital gains tax at 10% (plus surcharge as applicable plus 4% Health & education cess) if the total long term capital gains amount from equity oriented mutual funds/ equity shares exceed ₹1,00,000 in a year.

5. Investment horizon

Index funds can experience a lot of fluctuations in a short period. These fluctuations have the potential to average out the gains on your investment if they last long. Hence, index funds are ideal for those with a long-term investment horizon. If you choose to invest in index funds, you must be patient enough to allow the fund to perform at its maximum potential.