Things to Consider Before Investing in Index Funds

Mutual funds are a low-cost and transparent investment option. However, choosing from different schemes can be a daunting task. Moreover, a low-performing fund can reduce the overall returns on your portfolio.

Over the last few years, index funds have gained popularity for offering significant returns in the long run. Read on to know more about these funds.

What are index funds?

These funds are types of mutual funds that track a particular index like the BSE Sensex 30 or the Nifty 50.

The fund managers do not use their research and discretion for stock selection. They mimic the stockholding and the weightage of each company based on the underlying benchmark index.

For example, an index fund tracking the Nifty 50 will invest the entire corpus in the top 50 companies based on the free-float market capitalization in the same proportion as comprised in the index.

Things to consider before investing in index funds

Investing in index mutual funds may be less risky than large-cap funds. However, it is not completely risk-free. Before you invest in one of the several available options, here are four things to consider.

Time

To maximize your returns, it is recommended you invest in index funds for a longer period. It is advisable to hold your investment for at least five years to maximize the gains.

And if you hold the funds for seven years, it can be more beneficial. A longer holding period ensures your investment can tide through the short-term market volatility.

Since the recommended investment horizon is longer, you must not invest your contingency savings in these types of mutual funds.

Index category

There are several categories of index funds in India. Although there are a large number of indices on the stock exchange, index funds are available only for some of these.

So, if you choose funds like Tata Index Sensex Fund, LIC MF Index Sensex Fund, or Nippon India Index Fund – Sensex Plan, you are primarily investing in the top 30 companies in India.

Alternatively, if you want to invest in the top 50 Indian companies, you may choose funds that track the Nifty 50. Within this category, you can either opt for Nifty 50 Equal Weight or Nifty 50 Index.

The investee companies in both these types of funds are the same but there is still a minor difference. If you choose the Nifty 50 Index, some of the investee companies get more weightage while the others have a smaller weightage.

On the other hand, if you opt for Nifty 50 Equal Weightage, all the investee companies have the same weightage.

The concentrated portfolio of the Nifty 50 funds carries a slightly higher risk when compared to the equally distributed portfolio of the Nifty 50 Equal Weightage Index funds. You can make the decision based on your risk appetite.

Tracking error and expense ratio

Some of the best index funds have lower tracking error and expense ratios. Tracking error is primarily the deviation of the fund's performance when compared to the returns delivered by the underlying benchmark index.

This error arises because even though the fund managers try their best to mimic the index, there is some difference between the two. The expense ratio includes expenses like administrative costs and the lower the ratio, the higher will be your actual returns.

Compared to actively managed mutual funds, the expense ratio for index funds is lower. This is because the fund managers do not need to actively analyze various stocks and make investment decisions, which reduces the time and size of the research team.

How index funds are taxed

The income received from your investments in index funds is taxable as per your income tax slab rate. If you exit your investment before one year, the short-term capital gains (STCG) earned are taxed at 15% plus cess (currently at 4%).

On the other hand, long-term capital gains (LTCG) earned on investments held for more than one year are tax-exempt for up to INR 1 lakh and any amount exceeding this is taxed at 10% plus cess.

Benefits of investing in index funds

Before discussing the benefits of these funds, understanding what is an index fund and knowing the difference between active and passive investing is important.

The fund manager of a diversified equity fund decides on which stocks to buy and sell, and this is an example of active investing.

On the other hand, the fund manager of an index fund only tracks the underlying benchmark to make investment decisions, and this is known as passive investing.

Here are some benefits of putting money in index funds.

  • Because these funds mimic the underlying benchmark, the portfolio mix is simpler and more predictable than active funds.
  • With discipline and patience to stay invested for the long term, you can enjoy significant returns on your investments.
  • Human bias is eliminated as the fund managers do not have to study various companies and make investment decisions.
  • Compared to actively managed funds, the costs associated with even the best Indian index funds are lower.

Which are the best index funds in India?

While choosing the best funds to invest in, it is important you do not look at the top-performing funds every year as this will result in adding several mutual fund schemes to your portfolio over a period.

The primary objective of investing in index funds is to avoid having a large number of funds in your portfolio. Some of the good options to consider include Sensex 30 and Nifty 50 funds. You may invest in these funds for the long term and see your investments grow over the years.

Types of index mutual funds

You may choose from different types of index funds, which are classified as below:

Broad market funds

These capture the wider market and have smaller expense ratios and are suitable if you want to include different shares in your portfolio.

Global index funds

These funds provide international exposure. You can invest in indexes across different geographies to benefit from emerging regions and frontier markets.

Market capitalization funds

They invest in companies based on their market cap and include small-cap, mid-cap, and large-cap funds.

Bond-based index funds

These funds combine bonds maturing in the short, medium, and long-term to deliver stable returns.

Earnings-based funds

These can either be growth or value indexes; the growth index comprises companies that grow faster than others while the value index includes stocks that are trading at lower profits when compared to their earnings.

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