Investing in Index Funds for Beginners
India has two recognized indices
- S&P BSE Sensex – An index of stocks of 30 companies listed on the BSE, commonly referred to as Sensex
- Nifty 50 – An index of stocks of 50 companies listed on the NSE, commonly referred to as Nifty
These indices represent top companies based on their free float market capitalisation. A robust index construction methodology is adopted to construct and maintain these indices, thereby ensuring that human bias is eliminated. These indices represent the country’s largest companies, with solid fundamentals and a proven track record. Index funds make investing in such companies easier for retail investors, aiming to replicate the index in their investment portfolio.
What is an Index Fund?
Index funds are category of mutual funds which aim to replicate an underlying benchmark index. Such mutual fund schemes buy the same number of stocks, in the same proportion, as present in the index. They do not take any active sector or stock exposure other than the index constituents. They also try not to deviate from the different weights of securities in the benchmark index.
Since the index fund's constitution mirrors the benchmark index, the investors may generate similar returns given by the benchmark indices through index funds.
Benefits of an Index Fund
Index funds provide the following benefits to the investors:
1. Lower cost
Since index funds are managed passively, the investment and fund management team only need to track the underlying index and implement the changes whenever they happen. There is no flexibility with the fund manager to deviate from the index securities or weights as that of the underlying indices. Consequently, the fund management charges for such funds are lower, leading to index funds having lower expense ratios than actively managed funds.
Underlying indices are constructed following a well-set methodology and with back-testing of data over longer period, a broad-based index represents different market sectors and segments within the same index. Therefore, investing in an index fund/ ETF s provides the same diversification across the market segments and the market as a whole.
3. Mitigation of risk
The investment risk is classified into two categories – systematic risk and unsystematic risk. Systematic risk refers to the broader market risks, which is the risk of movements in the equity markets due to changes in the macroeconomic environment. On the other hand, unsystematic risks are the risks which are specific to company or industry which they operate.
Index funds carry only the systematic risk, since they replicate the market indices. However, funds tracking the underlying index may have tracking error, which is an amount of deviation caused in tracking/mirroring the index.
How do Index Funds work?
Index funds work just like other mutual fund schemes and the only difference between the two is in the investment strategy. While fund managers taking the investment decisions in actively managed mutual funds, index funds track a specific underlying index.
The moneys invested and redeemed from index funds is adjusted in the investment portfolio and the fund manager ensures that the composition of investment portfolio continues to be in sync with the composition of the underlying index. Here is a summary of the activities that happen in the case of index funds:
Creation of MF units
The mutual fund creates index fund units with securities in the same weights as the underlying index, so that the investment portfolio always mirrors the underlying index.
Transactions by the investors in Index Funds
One can invest in index funds in the same manner as any other mutual fund scheme, wherein the transactions happen through mutual fund house. The mutual funds units are created or cancelled at the prevailing day-end NAV (Net Asset Value) when the investors buy or sells the index fund units.
Valuation changes of Index fund units
Since the underlying investments for the units is the investment portfolio tracking the underlying index, any changes in the value of the investment portfolio will drive the changes in the NAV of units of the index fund.
Index Funds vs. Actively Managed Funds
Since Index funds are passive investment products, fund managers don’t have any flexibility to invest beyond the index securities or change the weights of different securities.
In contrast, actively managed funds follow active investment strategy wherein the fund manager decides about which stocks to invest in and in what proportion.
When it comes to investing, investment risks are classified into systematic and unsystematic risks. Systematic risks are inherent to investing and attributable to risk of adverse movements in valuation due to macroeconomic changes including inflation, interest rate etc.
Index funds adopt passive investment strategies wherein there is no discretion for the fund manager to invest beyond the underlying index composition. As such, unsystematic risks are automatically eliminated with index funds. In contrast, actively managed mutual funds carry both systematic and unsystematic risks.
Who should invest in Index Funds?
Investors who are willing to trust the broader market wisdom and are content with the benchmark returns can consider investing in index funds. Index funds further provide several benefits to the investors which have already been discussed in the paragraphs above. However, these funds don’t aim to outperform the underlying index by taking active bets.
Index Funds – things to consider as an investor
While there is no differentiation in the investment portfolio amongst different index funds tracking the same index, one may consider the following points when buying an index fund:
- Total Expense Ratio (TER) – Since an expense ratio is charged to the scheme, the returns are directly impacted by the TER. In the case of two index funds tracking the same underlying index, the returns of the fund with a higher TER will be lower.
- Tracking Error (TE) – Tracking Error refers to the inefficiencies in investment management resulting due to the time difference on when the changes happen in the underlying index and when the changes are implemented in the investment portfolio of index fund. Higher the tracking error of the index fund is, higher would be the variance between the fund's performance and performance of underlying index.
How to invest in an Index Fund in India
The process to invest in index funds is similar to that for investing in other mutual fund schemes. As such, one can visit any of the Official Points of Acceptance (POA) to submit the duly filled application form along with a crossed cheque in favour of the mutual fund house and the specified scheme. One can also undertake an investment transaction digitally in index funds through the website/mobile apps of the mutual fund house or the Registrar & Transfer Agent (R&TA).
However, investments can be made only when KYC verification for the investor’s PAN is in place. Further, once the investment has been processed, there is no differentiation by the mutual funds based on the mode of transaction and the same NAV is applied for the mutual fund units whether applied digitally or physically.
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
The taxation of index funds depends upon the underlying index they are replicating. If the underlying index is an equity index, the taxation will be in line with the tax treatment for equity shares, where any Short-Term Capital Gains (STCG) (with an investment period of less than 12 months) are taxed at 15% (plus applicable cess and surcharge) and the Long-Term Capital Gains (LTCG) are taxed at 10%. Such long-term capital gains considered in aggregate for equity shares and equity funds are also exempt up to ₹1 lakh a year and only gains beyond ₹1 lakh are taxable.
In case the ETFs are tracking a debt index, like SDL Index, etc., the specified cut-off period for classification as LTCG and STCG is 36 months. If the investment has been held for less than 36 months, the gains are classified as STCG and taxed at the regular tax rates applicable to the investor. However, in case of mutual fund units have been held for 36 months or more, LTCG on such debt fund units is taxed at 20% (plus applicable cess and surcharge) with benefit of indexation.
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 to take 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. Further, the unsystematic risk of investing in equity markets gets taken care of too. Hence, one may consider investing in index funds after reviewing one’s investment goal, risk appetite and time horizon.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
The tax provisions mentioned in the article are for illustrative purposes only and are updated as per the Union Budget 2022 presented in the Parliament in February 2022. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the investment date.