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What are Index Funds and How to Invest?
Are you looking for a long-term, less risky form of investment
Index funds can be an ideal option.
If you are a first-time investor with little knowledge about the meaning and operations of index funds, the following sections will provide you with a comprehensive understanding of this investment instrument.
Stay tuned!
Table of Contents
What are Index Funds?
Index funds are a type of mutual fund that are passively managed by fund managers. Here, the investment copies the portfolio of specific indices indexes such as NSE 50 (Nifty) and BSE Sensitive index (SENSEX), popular indices in India. The asset allocation is similar to that of a particular index, meaning the investment comprises all the shares a specific index contains in the same proportion.
Now that you know what is an index mutual fund, we can move on to how they work!
How Do Index Funds Work?
When an investor invests in index funds, the fund manager utilizes investors’ money to invest in stocks in the same manner as the index they are tracking. Here, fund managers do not play an active role in choosing industries or stocks to furnish the fund’s portfolio; instead, they follow the index and invest accordingly.
For instance, a NIFTY Index fund invests in stocks of various companies that hold the NIFTY 50 Index in the same way or proportion and will expect to get a return similar to that of the NIFTY 50 Index
An example will clarify these roundabout sentences. Suppose Reliance company has an 11.5% stake in the NIFTY 50. Therefore, the fund manager of the NIFTY 50 Index will create a portfolio giving a similar weightage of stocks, meaning stocks of the company will be 11.5%. The same weightage will be given to other stocks of different companies.
Further, if a particular stock's weightage has gone up or down, fund managers will follow the same movement. Moreover, if stocks are sold and new stocks have been added, fund managers will replicate those actions as well and sell all the holding of stocks and purchase stocks following the same weightage in an index.
All these actions (buying and selling) are done passively; hence, they do not require a team.
As questions like what are index funds, and how do they work are clear to you, we can now learn about the different types of index funds in detail.
Want to know about the benefits of investing in Index funds? Read along!
What are the Types of Index Funds?
Read the table attentively, and you will learn about different types of index Funds.
What are the Benefits of Index Funds?
1. Low Expense Ratio
One of the major benefits of index funds is their lower cost. Its expense ratio cannot exceed 1%. The costs of active funds are much higher than passive funds, such as index funds. The asset allocation does not frequently change as it happens, so only when there is a change in the underlying asset allocation. Therefore, trading expenses are easy to keep on the lower side.
2. Steady Income
Stocks comprising index funds usually belong to well-established companies that are not easily affected by market fluctuations. It means investors can expect a steady and consistent return.
3. Automatic Clean-Up
Portfolios of index funds enjoy an automatic clean-up. The indices remove underperforming assets. Therefore, as an investor, you need not worry even if you have invested in an underperforming or slow-performing asset, as the index will do this job on your behalf.
4. Passive Fund Management
Since index funds do not require any active management, investors need not worry about the performance of certain bonds. Instead, they can focus on evaluating their portfolios from time to time.
5. Free of Security Risk
Index funds do not have security risks as the investment is made in a pool of various assets. Here, changes in some indices cannot practically damage the indices used.
6. Tax Benefits
The gains from index funds are taxable and primarily depend on two factors. These are,
- Holding period (the time you want to stay invested)
- Type of index fund chosen (equity or non-equity)
The tax on short-term capital gains is 15% (plus surcharge, if applicable and cess), and the tax on LTCG is 10% (plus surcharge, if applicable and cess) if the gains go beyond ₹1 lakh.
For instance, if STCG is ₹75,000, investors must pay 15% of ₹75,000, which is ₹11250 as STCG tax. On the other hand, if LTCG is ₹4 lakh, you have to pay LTCG tax on ₹3 lakh (after the deduction), which will be ₹30,000 (10% of ₹3 lakh).
Who Should Invest in Index Funds?
The investment decision of a mutual fund entirely depends on the risk tolerance and investment planning of investors. Index funds are an ideal choice for those who have a low-risk appetite and expect a steady return. Further, these funds do not demand thorough tracking. For instance, if you want to invest in equities but at the same time want to avoid the risk associated with actively managed funds, you can select NIFTY or SENSEX index funds.
The benefits of investing in index funds (mentioned earlier) seem promising, and now that you know about the ideal index funds, you can invest in them as per your suitability. However, there are certain factors that every investor must be aware of. Read along!
How to Invest in Index Funds?
There are wide ranges of indexes that investors can track using index funds. To invest in index funds in this nation, keep the following things in mind.
- Decide the investment and investment period.
- Pick an index.
- Verify their identity.
- Register with an Asset Management Company (AMC), purchase through authorized distributors, or open an account with a broker selling index fund shares.
- Start investing.
Now that you know how to invest in index funds in India, you must be aware of the limitations of this type of fund.
Things to Consider Before Investing in Index Funds
1. Risk Return Aspects
The risk-return aspect is another important parameter of investing. All investors want to invest their valuable money into something more secure and safe. Index funds track a market index and manage funds passively. Therefore, they are less volatile than actively managed funds and have less risk associated with them.
Note: As index funds mimic the performance or action of the index, investors must be careful about tracking errors. Hence, before investing in this type of investment instrument, investors must find one with a reduced tracking error.
2. Investment Plan
Every investor has an investment plan and returns expectations. For index funds, investors can opt for a long-term horizon. Though some market movements can be experienced in the case of short-term, long-term plans have low chances of direct market effect. Further, with an investment horizon of 7 years, you can expect an average return of 10%-12%. Thus, with an index fund, you can perfectly align with other long-term investment plans and continue investment activities as long as you want.
3. Taxability
Before investing, investors must know about the taxability of investment instruments. Like equity funds, index funds are subject to tax. The mention of tax leads us to the discussion of index funds' tax benefits.
4. Limitations
Index funds do not offer flexibility to the fund manager while handling market downsides. In the case of active funds, fund managers have the liberty to select stocks in better-managing markets at times when assets perform poorly due to bearish market conditions. However, index funds have to abide by the benchmark rules during both bearish and bullish market conditions. In addition, the returns are consistent but low in comparison to actively managed funds.
Also, as index funds follow index movement, changes in index composition lead to an adjustment of index funds, which demands transaction costs. These costs reduce the benchmark returns.
Now that investors know about index funds, various types, working methods, benefits, and everything related to it, they can invest in it as per their investment objective and suitable investment horizon.
Disclaimer: The information provided on this website is for general informational purposes only and should not be construed as financial, investment, or legal advice. While we strive to provide accurate and up-to-date content, we do not guarantee the completeness, reliability, or suitability of the information for your specific needs.
We do not promote or endorse any financial product or service mentioned in these articles. Readers are advised to conduct their own research, consult with financial experts, and make informed decisions based on their unique financial circumstances. Any reliance you place on the information provided here is strictly at your own risk.
FAQs about Index Funds
What is the ideal investment horizon of Index funds?
Is there any investment risk in index funds?
What is the chargeable fee of an index fund?
What is an Index Fund?
What are the Types of Index Funds?
The following are the types of index funds:
- Broad Market Index Funds
- International Index Funds
- Bond-Based Index Funds
- Market Capitalization Index Funds
- Earnings-Based Index Funds
What are the benefits of index funds?
The key benefits of index funds are:
- Low Expense Ratio
- Passive Management
- Diversification
- Steady Income
Other Important Articles about Mutual Funds
Disclaimer
- This is an informative article provided on 'as is' basis for awareness purpose only and not intended as a professional advice. The content of the article is derived from various open sources across the Internet. Digit Life Insurance is not promoting or recommending any aspect in the article or its correctness. Please verify the information and your requirement before taking any decisions.
- All the figures reflected in the article are for illustrative purposes. The premium for Coverage that one buys depends on various factors including customer requirements, eligibility, age, demography, insurance provider, product, coverage amount, term and other factors
- Tax Benefits, if applicable depend on the Tax Regime opted by the individual and the applicable tax provision. Please consult your Tax consultant before making any decision.
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