Index funds are most suitable for investors who want higher-than-normal long-term returns by investing in equity but do not want to take on high risk.

By Hemanth Gorur,

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Equity investments usually entail volatility in price and require analytical effort not only to make a good investment but also to track it thereafter. So much so that equity has become synonymous with high risk and high effort. This need not be the case. Index funds solve the dual problem of high risk and effort for investors so that they can easily make equity investments at lower cost. Let us see how.

What are indices and index funds?

An index (plural: indices) on the stock market is a weighted average composite score that tracks the stock market’s performance over time. It is calculated using the stock prices of selected stocks that are representative of the market in some way. The BSE Sensex and the NSE Nifty are examples of this.

Index mutual funds, or simply ‘index funds’, are a class of mutual funds called ‘Passive Funds’. These funds invest in the same securities as the underlying index they track, and thus are passively managed funds. Since the fund manager merely tries to mimic the asset allocation of the underlying index, there is no investment strategy followed by the fund. The only stipulation is that at least 95% of the investment should be in the securities of the underlying index being tracked.

Characteristics of index funds

Unlike actively managed funds which use investment strategies to perform better than the market and thereby may introduce high risk into your portfolio, index funds are moderate risk investments. Correspondingly, the returns are tied to that of the underlying index being tracked.

Since the fund manager is not expending any extra effort to decide on which securities to invest in, index funds usually have low fund management expenses—called expense ratio—and thus are less expensive options than actively managed funds. As per SEBI Mutual Fund Regulations, the expense ratio for index funds cannot exceed 1% of the daily net assets.

Index funds are not traded on exchanges. Hence, liquidity of index funds is lower than regular funds. However, they are open-ended schemes, meaning you can always sell your mutual fund units back to the mutual fund and redeem your money at any time.

As for taxation, index funds are treated as equity-oriented funds as per the Income Tax Act. If the investment is held for less than a year, the returns are treated as Short Term Capital Gains (STCG), attracting an income tax rate of 15%.
If held for more than a year, any gains over `1 lakh are treated as Long Term Capital Gains (LTCG) taxable at 10% without indexation. For this, the returns would be calculated based on the purchase price, or the NAV as on January 31, 2018 if you had invested before that, whichever is higher.

Who should invest in index funds

Index funds are most suitable for investors who want higher-than-normal long-term returns by investing in equity but do not want to take on high risk. This does not mean index funds have no risk. If the market goes down, your index fund NAV will also go down. In which case, you may be better off redeeming your index fund investment before the market starts falling and redirecting the proceeds into debt funds or assets such as gold or term deposits.
When investing in index funds, you should look for what is called the Tracking Error, which is the difference between the index fund’s returns and the market returns. This should be as low as possible. Additionally, choose index funds that have expense ratios lower than 1%. If the fund management costs are higher, then it is a red flag.
Index funds work well when you want a low expense investment option and are prepared to give it time to grow. As long as the economy grows, your investment will also grow.

The writer is founder, Hermoneytalks.com

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  • Index funds invest in the same securities as the underlying index they track, and thus are passively managed funds
  • Expense ratio for index funds cannot exceed 1% of the daily net assets as per Sebi norms
  • Index funds work well when you are prepared to give it time to grow
  • Tracking Error, the difference between the index fund’s returns and the market returns, should be as low as possible

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