Here's all you need to know about index funds
Posted: Sep 26, 2020
What are index funds?
Index funds imitate a stock market index such as NSE Nifty, BSE Sensex, etc. These mutual funds follow a passive style of management. This means that the fund manager invests in similar securities that have similar proportions as in the underlying index it tracks.
Who should invest in Index Funds?
An investor should invest in mutual funds according to their financial goals, investment horizon and risk profile. Index mutual funds are ideal for risk-averse investors who are looking for foreseeable returns from their investments. These funds do not require any extensive research and tracking. For instance, if you want to invest in equities but do not wish to expose yourself to the risks associated with equity mutual funds, you can opt for a Sensex index fund.
What things should you consider as an investor?
As an investor, you should consider the following features before you decide to invest in index funds:
Index funds aim to imitate the performance of their underlying market index. Unlike actively managed mutual funds, they do not try to beat the benchmark. One should be careful that the returns generated may not always be at par with their underlying index, thanks to tracking errors. The lower the errors, the better the index fund tends to perform.
As index funds map a specific market index, they are less prone to equity-linked risks and volatilities. It's a good idea to invest in these funds to generate optimal returns amid a volatile market. However, things could get ugly during a market downturn as index funds lose their value during a market slump. Hence, it's always advised to have a blend of actively and passively managed funds in your portfolio.
Cost of investment
The expense ratio of index funds is typically 0.5% or less, as compared to actively managed funds with an expense ratio of 1 to 2.5%. This is because, in the case of index funds, fund managers are not required to formulate any investing strategy and constantly track the market. However, it should be noted that even a fund with a lower expense ratio can generate higher returns on investment.
You earn capital gains, which is taxable, upon redeeming the units of your index fund investment at a premium. The rate of taxation depends on the holding period of your investments, 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%. Long-term capital gains (LTCG) or gains earned with a holding period of 1 year or more are taxed at 10%* without the benefit of indexation.
Index funds can experience many fluctuations in the short term. These fluctuations can average out the gains on your investment if they last long. Hence, index funds are ideal for those investors 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.
Just like actively managed mutual funds, there are various benefits of index funds. Whether you decide to invest in mutual funds online or index funds, ensure that your investments are in line with your investment portfolio. A good portfolio is a blend of mutual fund investment and index funds. Happy investing!
- LTCG over Rs 1 lac is taxed at 10%
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