Investing in Index Funds for Beginners
India has two recognized Indices
S&P BSE Sensex – An index of stocks of 30 companies, commonly referred to as Sensex
NSE Nifty50 – An index of stocks of 50 companies, commonly referred to as Nifty
These indices represent top companies based on their free float market capitalization, subject to other index criteria as well. A robust index construction methodology is adopted to construct and maintain these indices; thereby also ensuring human biases is eliminated in the process. It goes without saying that the index tends to comprise of the companies with strong fundamentals, and proven track record.
As such, the investors are inclined towards making investments in such companies and benefit from higher earnings from the stock selected through tested techniques. However, since these indices are not a stock or security in themselves, the investors need to invest in the index constituents in the same weight as the index. Further, they also need to continuously review the index constitution for any changes, so that the same may be made in the investment portfolio as well.
Index funds make this easier for retail investors as such mutual fund schemes aim to replicate the index in their investment portfolio, by buying the same number of stocks in the same proportion as they are in the index. Such funds do not take any active sector or stock exposure, other than the index constituents or in different weight than the chosen index.
Benefits of Index Funds
Index funds provide the following benefits to the investors:
1. Lower Cost– Index funds are available at a lower expense ratio relative to actively managed funds.
2. Diversification– Such funds provide diversified exposure to various segments of the market & also the market as a whole.
3. Mitigation of Risk– Taking an exposure in the index helps in mitigation of unsystematic risk for the investors.
How to Invest in Index Funds?
The procedure for investing in index funds is not different from investing in other mutual fund schemes. The investors may invest in index funds by filling an application form for the desired scheme and submit it at in the authorized collection center of that mutual fund or the Registrar & Transfer Agent. The investors may also invest in such funds by visiting the website of the mutual fund house, filling all such information online and making an online payment. In line with the other mutual fund schemes, the NAV of such funds is declared at the end of the day and thus, the unit allotment information is sent to the investor on the next business day.
Taxation of Index Funds
Since such funds invest the entire amount in equity instruments, such funds are taxed in line with the tax treatment offered to equity-oriented funds. As such, any short-term gains from index funds (with an investment period of less than 12 months) are taxed at 15% (plus applicable cess and surcharge), while the long-term capital gains are taxed at 10%. Such long-term capital gains are also exempt up to Rs.1 lakh a year and only gains beyond Rs.1 lakh are taxable.
Answering the Million-Dollar Question – Should you invest in Index Funds?
The index funds may help replicate the market returns, as provided by the underlying index. So, if you are looking for taking the market exposure (equity as an asset class) at a relatively cheaper cost, index funds are the right thing to invest in. Since the fund manager cannot take any investment call, except maintaining the index weight in the same stocks, the emotional and human bias gets eliminated and further, the unsystematic risk of investing in equity markets gets taken care off.