What are Index ETFs?
Index ETFs are exchange-traded funds that attempt to closely replicate and track a benchmark index such as Nifty 50, BSE S&P 500, etc. They’re similar to index mutual funds. However, for index mutual funds, redemption happens at a single price each day [the closing Net Asset Value (NAV)]. While the index ETFs trade on the stock exchanges. Therefore, one can buy and sell just like stocks during trading hours. Index Exchange Traded Funds give exposure to multiple stocks in a single transaction.
An Index comprises top companies pertaining to the broad market it tracks. For example, the Nifty50 index comprises the top 50 companies on the basis of their free-float market capitalization. An Index Exchange Traded Fund tracking the Nifty 50 will try to replicate the index closely and will have the same 50 companies in its portfolio.
There is often a certain difference between the index ETFs and the underlying index. In other words, index ETFs don’t always match the underlying index perfectly. Often there is some tracking error or a gap between the ETF’s market price and the fund’s net asset value (NAV).
How Do Index ETFs Work?
Index EFTs can be specific to a sector, theme, or market capitalization. Furthermore, these ETFs are passive investment funds. In other words, the portfolio composition changes only when the asset allocation in the underlying index changes.
Thus, index ETFs are popular investment options among investors who wish to generate benchmark returns. Furthermore, these funds are low-cost investment schemes with a diversified investment portfolio.
The price movements of Index Exchange Traded Funds are closely related to the index they follow. To elaborate, the index ETFs portfolio composition closely corresponds to that of the index it follows, and thus the price movements are similar.
Who Should Invest in Index ETFs?
When choosing an Index ETF for investment, it is necessary to define your investment goals and tenure. On the basis of your goals, risk tolerance levels and investment horizon, you can pick the right fund to invest in.
For example, if you are an investor who wishes to invest in the top 50 companies in India, then the Index ETF that tracks Nifty 50 is suitable. Similarly, if you wish to have exposure to a particular sector, you can pick an Index ETF that tracks that particular sector.
These ETFs are suitable for investors with a long term investment horizon. Since these ETFs are passive investment funds, they suit investors who do not wish for active fund management. The expense ratio/ fees are low for these ETFs as they are passive funds.
Thus investors with not much time to manage their investments and looking for low-cost investments can consider Index Exchange Traded Funds.
Things to Consider as an Investor
Following are the things to consider while investing in Index Exchange Traded Funds:
Index ETF funds are suitable for investors who have a long-term investment horizon. The returns may fluctuate in the short term. However, it tends to even out in the long run. Thus it is important to have a long term investment horizon to enjoy significant returns.
Capital gains from these ETF funds redemptions can be either short-term or long-term, depending on the holding period.
The short term capital gains are taxable at 15%, and long-term capital gains are taxable at 10% without the benefit of indexation. However, long-term gains above INR 1,00,000 are taxable at 10%.
Index ETFs track a broad market index, themes and sectors. When selecting this ETF, you should have a clear investment strategy in mind. It is critical to choose an investment scheme that aligns with your goals. For example, the portfolio should contain a broad market index, a specialized sector, a region, or a thematic index.
Not all ETFs that track the same index perform the same way. Due to tracking error, performance may fluctuate by as much as half a percentage point. Before investing in this ETF, you should consider the fees, liquidity of the fund, and tracking error.
Advantages of Index Exchange Traded Funds
Following are the advantages of investing in Index ETF funds:
- Real-Time Prices: Since Index Exchange Traded Funds are listed on the stock market, you can buy and sell them at any time during trading hours.
- Low Cost: These ETFs are passive funds. Thus the number of transactions are lesser. As a result, the fund management costs are lower. The portfolio composition changes only when the index composition changes. Minimal research costs and portfolio turnover makes index ETFs the lowest-cost ETFs.
- Volatility: These ETFs are low volatile schemes. Broad-based index ETFs have less volatility in comparison to sector-specific or theme-specific mutual funds.
- Bid-Ask Spread: The bid-ask spreads for these ETFs is typically narrow, thus allowing smooth execution of orders.
- Diversification: Index ETFs have a diversified investment portfolio that tracks an index belonging to a broad market category, sector or theme. Thus, you can enjoy exposure to all the stocks that form part of an index by investing in an Index ETF.
- Passively Managed Funds: Index ETFs are passive investment schemes. The funds replicate the benchmark index closely. Thus, it reduces the risk of fund managers’ poor stock selection decisions.