A Simplified Guide to Index Funds

It is becoming increasingly obvious these days that investment is the best way for most people to achieve their financial goals. Costs of education are rising and the advantages of going for study abroad are becoming more and more obvious.

For many people, these rising costs of education have necessitated a changed approach to finances. A good investment strategy and portfolio is clearly the way to go. However, many beginner investors do not know enough about investments and how or where to invest. 

In this guide, we cover index funds: what they are, how they work, who should invest in them and things to consider. If you have been thinking about investing in mutual funds or ETFs, read on to know more. 

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What is an Index Fund?

Index funds are a type of passively managed, equity funds. As the name suggests, these funds have a portfolio that is made to imitate a financial index, like BSE Sensex, NSE Nifty etc. Both ETFs and mutual funds can be index funds. Returns from an index fund, typically mirror the growth of the index that they are tracking.

How Does an Index Fund Work?

An index fund works by tracking a financial index. A financial index is a measure of the stock market or a subset of the stock market. An index fund consists of the same stocks that comprise a certain index, in the same proportions. So if, for example, a particular index fund is tracking Nifty, it’s portfolio will have the same 50 stocks that comprise Nifty. Then, the performance of the fund will depend on the performance of Nifty. 

Unlike an actively managed fund, index funds do not have a team of analysts and experts constantly researching the market and creating strategies. The fund manager only ensures that the fund tracks its respective index as closely as possible.

Things to Consider When Investing in Index Funds

1. Risks and Returns

Index funds are passively managed and track a financial index. This means that they are less volatile than other equity funds that are actively managed and hence, less risky. This is because actively managed funds strive to beat their benchmark but index funds track particular financial indices and try to remain as close to the benchmark as possible.

This means the returns of an index fund usually replicates the performance of the index. This makes these funds reliable and lucrative during a market rally but less so during a slump. 

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One thing to keep in mind, however, is the tracking error. Most index funds do not replicate their respective indices exactly. There is a small deviation which is called a tracking error. You should always choose a fund with a low tracking error to reduce risk. 

2. Investment Timeline and Goals

Since index funds are considered lower risk funds, they are suitable for investors looking to make long term, passive, investments. These can be investments made for the future education plans of a very young child or retirement plans.

With long term investment windows, any short term fluctuations can be balanced out or averaged. But if your goals are less long term, for example, education plans for an older child, you should consider investing in a more actively managed fund. A good financial advisory service can help you make these decisions.

3. Investment Costs and Fees

Index funds are passively managed. Since these funds track indices and don’t require active management, they incur lesser fees. An actively managed fund has to pay for analysts and experts to do research and create investment strategies.

A passively managed fund does not have to do that. They have lower operating and management fees, transaction charges, etc. This means that these funds have a lower expense ratio ( the percentage of your total investment that you have to pay to the fund as management fees and other charges).

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4. Taxation

Index funds are subject to dividends distribution tax (DDT) and capital gains tax. DDT is deducted at source when the fund pays its dividends to stakeholders. The DDT is generally applied at a rate of 10%. Capital gains tax is the tax levied on the capital gains made when you redeem units of your index fund.

The amount of tax depends on your holding period. If you held the units for less than a year, then you will have to pay short term capital gains tax (STCG) which is 15%. Capital gains from a holding period of above one year are considered long term capital gains (LTCG) and taxed at 10%. LTCG under Rs.1 Lakh is not taxable.

Who Should Invest in an Index Fund?

Index funds are ideal for investors who want to invest in the equities market but do not want to take a lot of risks. If you are open to a long term investment with relatively low but fairly predictable results, index funds can be a good option for you. 

Keep in mind that index funds will follow the index and not give you any market beating returns. If you are looking to make investments for your child’s education plans, you may want to stick to index funds for the stability they offer. However, a much better option would be a diversified investment portfolio with index funds as one of the components. 

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Education plans are rather high stakes goals and so it is understandable to want to go safe. However, education, especially if you plan to study abroad, is also expensive. Actively managed equity funds tend to have generally higher returns. Keeping both in your portfolio can help you get the best of both worlds, general stability as well as good returns.

Key Takeaway

Index funds are a good and reliable way of passive investment for people who do not have the time to constantly monitor and manage their portfolio. They are especially useful when the markets are doing well and financial indices are on a general rise. However, recession and economic instability can cause a slump and bring down the value of index funds. To offset such eventualities, it is important to diversify your portfolio. 

Financial planning, afterall, requires active effort and involvement. The securities and assets you invest in, should be properly aligned with your financial goals. If you lack the know-how or expertise to figure these out yourself, you can always consult a financial planner or other such services. For specific goals like education plans, you can hire specialised financial planning experts like EduFund.

A good investor understands his investments and takes risks in accordance with his goals and his capacity. Therefore, putting in the time to figure out what kind of investor you are and what kinds of investments are best for you, is always a worthwhile endeavour.