Index Funds

Diversification is a critical factor for a well-rounded investment portfolio, and index funds implement this strategy to generate higher returns. 

 

With minimal risk factors and better returns, these mutual funds are ideal for investors looking to adopt the route of passive investment.

An index fund invests in stocks that mirror a specific stock market index, such as BSE Sensex or NSE Nifty. These funds implement the principle of passive investment. 

 

In simple words, the fund manager maintains your securities similarly to the underlying index in the same proportion without altering the portfolio composition. These funds provide returns similar to the index funds they track.

 

Suppose an index fund tracks the NSE Nifty index, holding 50 stocks in similar proportions as the index, which includes bonds, equity and equity-related instruments. The fund makes sure to invest in all securities that a particular index tracks. 

While actively managed funds usually aim to exceed their benchmarks, an index fund is the type of mutual funds that simply manages to replicate the underlying index's returns.

Check out some crucial parameters you must factor in before investing in index funds.

1. Investment Returns and Risk

Index funds passively track market indexes, providing lower volatility and reduced risks than actively managed funds.

 

Since index funds aim to replicate the index’s performance, you can get returns similar to the index. However, due to tracking errors, you may observe variations in fund returns with that of the index. 

 

So, prioritising funds with the lowest tracking error is important when selecting an index fund. 

2. Follow Your Investment Plans

If you plan to park your funds for a longer investment horizon, consider investing in index funds. While these funds may experience short-term fluctuations, they get back on track over time. So, you can align your long-term investment goals with these funds and remain invested for as long as possible.

3. Expense Ratio

The expense ratio is a small percentage of the fund's total assets that the fund house charges for fund management services. One of the significant advantages of an index fund is its low expense ratio. 

 

As the management of the index fund is passive, there is no need to create an investment strategy to research and select the right stock for investing. This efficiency helps reduce fund management costs, resulting in a lower expense ratio.

4. Taxation

As equity funds, these are subject to Dividend Distribution Tax (DDT) and capital gains tax. When a fund house pays a dividend, a DDT of 10% is deducted at the source before making the payment. 

 

Also, you earn taxable capital gains by redeeming the units of an index fund. If you earn capital gains for a holding period of up to 1 year, they are considered Short-Term Capital Gains (STCG) and taxed at 15%. 

 

If the holding period is over 1 year, they are considered Long-Term Capital Gains (LTCG). Long-term gains of up to ₹1 Lakh are not taxable, but those exceeding this threshold are taxed at 10% without indexation benefits.

Index funds were started around the mid-1970s. However, since the 2010s, they have seen immense popularity with the growth in passive investing, low fees, and bullish market sentiments.

 

Vanguard 500 Index Fund was the first Index Fund to be started in 1976, which closely tracks the S&P 500 in composition and performance. It means that the fund does more than replicate the index’s performances. It also ensures that the fund comprises the same securities in a proportion similar to the index.

 

Passively managed funds like index funds can be an excellent option if you prefer to opt for a simple investment strategy. Armed with this information, you can make wise investment decisions that align well with your financial goals.