What are the best Index Funds?
An index fund is a type of mutual fund that invests in a broader market index - like the Sensex OR Nifty. Moreover, all the stocks forming part of the Sensex and/or Nifty will become a part of the investment portfolio. These funds help investors in getting exposure to a broader market segment at a lesser cost.
The indices, Sensex and Nifty represent top companies based on their free-float market capitalization. Since the companies in both the indices are highly reputed and revenue-generating, investors wish to get benefitted from the same. Since these indices are not stocks but an index, investors need to invest in the index constituents in the same weight as the index.
How does the best Index Mutual Fund work?
An Index fund tracks a broader market index such as Sensex or Nifty and their portfolio will comprise the same stocks as in the Sensex or Nifty in the same proportions. Index funds are also known as passive funds since they track a particular index and do not require a high level of management of the fund.
The fund manager, who is managing the fund investments looks after the stocks which have to be bought or sold according to the composition of the underlying benchmark. As far as the return is concerned, the fund and the index deliver almost the same return. The difference between the two leads to the origination of tracking error which the fund manager tries to minimize.
Who should invest in an Index Fund?
Investors need to analyze their investment goals and understanding of risk before making an investment in index funds. However, below are a few points and investor might consider:
1. Investors should consider a long-term horizon for their investment
2. Index funds should be used in case the investors wish to avoid constant monitoring and tracking of the portfolio.
3. Index funds are available at a lower expense ratio as compared to actively managed funds.
4. If investors are looking for better returns than fixed deposit
Things to consider as an investor
Investment Horizon
Index funds are suitable for investors who have a long-term investment horizon. The fund return might fluctuate in the short-term but it usually evens out in the long run. It is important to stick to the fund over the decided horizon in order for the fund investments to perform well.
Financial Goals
If the investors make sure to stick to the investment horizon, index funds are able to offer better returns and which in turn will help the investors to achieve their financial goals. This can include retirement, wealth creation etc.
Taxation
Redemption of units of index funds leads to capital gain which can be either short-term or long-term depending on the holding period.
The short term capital gains are taxable @ 15% and long-term capital gains are taxable @ 10% without the benefit of indexation. However, for long-term gains, taxability arises only if the gain is above Rs. 1,00,000.
Expense ratio
Index funds usually have a lower expense ratio when compared to other funds. If there are two funds tracking, say Nifty, both will generate a similar return. The fund which will have a lower expense ratio will provide a higher return on investment.
How to invest in the best Index Funds?
The procedure for investing in index funds is no different from investing in other mutual funds. However, depending on your knowledge and time constraints, investors can opt for either below methods:
Offline Mode
This basically means making the investment through a broker or distributor. If opting for this mode, the investments are made through regular plans which have different returns and expense ratio. Alternatively, investors may invest by filling an application form for the desired scheme and submitting to the authorized collection centre of the mutual fund.
Online Mode
In this mode of investment, investors can visit the respective AMC’s website and choose the funds from there. The various funds offered by the AMC can be compared with each other in terms of returns, history of the fund etc. and can make the investment accordingly.
Taxation on Index Funds
A capital gain arises on the redemption of units of the index fund. The gains can either be short-term or long-term depending on the holding period of the units.
If the units are sold within a period of 1 year from the date of the allotment, this would give rise to short-term capital gain and is taxed @ 15%. Furthermore, the long-term capital gains are taxed @10%, above Rs, 1,00,000 without the benefit of the indexation.
For example, if there is a long-term capital gain of Rs. 2 lacs and the investor withdraws this amount after a year of investment, the tax will be levied on Rs. 1 lac and the amount payable will be Rs. 10,000.
Advantages of Index Funds
Lower costs
The index funds are available at a lower expense ratio as compared to actively managed funds. An index fund would typically charge between .20% to .50% while an actively managed fund charges higher than this. The higher the expense ratio, the lower the take rate for the investors.
Diversification
Index funds allow diversified exposure as all the leading companies that form part of the index. Auto diversification allows investors to reduce the risk of staying invested in a particular stock or sector like auto, pharma etc.
Mitigation of Risk
By investing in index funds, the investors take exposure in the index which helps them in mitigating the unsystematic risk for the investors. Unsystematic risk means a risk which is associated with a particular stock or industry.
Management
In the case of index funds, the allocation of assets is not up to the fund manager which reduces the scope of investors being at loss due to poor decisions of the fund manager. This saves investors time and they can utilize this time to re-evaluating their portfolios accordingly.
