5 Myths Everyone Should Know About Index Funds

Published On: 24-Mar-2020

Market indices such as S&P BSE Sensex, NSE Nifty50, etc. are created by adopting scientific methodologies and back-tested techniques. As such, the investors may wish to invest in such indices to have smooth investment experience. However, since such indices are not tradable security in themselves, it is a difficult proposition for the investors to construct a similar investment portfolio, which replicates such an index. Index funds may be suitable to meet such investing needs. However, there are certain myths about investing in index funds that investors must best wary of. 

Here are five myths everyone should know about index funds:

Index funds are completely Passive

While index funds aim to satisfy the passive investing needs of the investors, the prime decision of the investor to choose a particular index fund is in itself an active investment strategy. Further, the fund managers also need to stay active to manage the scheme liquidity in such a manner that the liquidity risk is mitigated to meet the redemption pressures. As per SEBI guidelines, index funds need to invest at least 95% of their net assets in the securities comprising the underlying portfolio in similar weightages. As such, the fund managers must manage the liquidity risk within the 5% range. 

One needs a demat account to invest in index funds

Since the broader market indices comprise of the securities traded on stock exchanges and transacted by the investors through demat accounts, it is often felt by the investors that one needs a demat account to invest in index funds as well. However, there is no requirement for the investors to have a demat account and instead, maintain the investment in index funds through the investor folios with mutual fund

All Index funds tracking the same index will have the same returns

Since the index funds tracking the same index will tend to have similar portfolio composition, the investors may believe that such funds following index investing strategy will generate equal returns. However, the investors must realise that the tracking error and expense ratio may impact the returns of index funds. Tracking error refers to the delays in the replication of the index composition to the scheme portfolio when such index composition changes. 

Index funds are risk-free investments

Given the long-term positive returns for the broader market indices, index funds are generally considered risk free investment. However, as the standard mutual fund disclaimer states, “mutual fund investments are subject to market risks.” Index funds are not an exception to the disclaimer, as the scheme returns tend to replicate the broader market performance and the markets may move higher or lower. But it is also a fact that index funds help the investors to mitigate the unsystematic risk for the investors and investors are only exposed to the systematic risks, i.e., risks of fall in the broader markets.   

Index funds are taxed as equity-oriented funds

While most of the index funds are taxed as equity-oriented funds, they enjoy special tax rates for long-term and short-term capital gains. The index funds tracking international equity indices may be taxed as non-equity-oriented funds. This is because, for a mutual fund scheme to be taxed as an equity-oriented fund, at least 65% of the net assets need to be invested in listed shares of domestic companies. 

It is now the time to debunk all the investing myths about the index funds and, instead, make an informed decision to invest in index funds. 

Note: The tax benefits as mentioned in the article are for illustrative purposes only, and are updated as per Finance Bill, 2020. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption and not on the date of investment.