What is a Low-cost Index Fund? Meaning and Low-cost Index Funds Returns and Taxation

Published On: 29-Oct-2020

Investors' first acquaintance with the equity markets is the benchmark indices, NSE Nifty50, and BSE Sensex. Such indices are an indicator of the broader markets. While some investors may consider equity investing as investing directly into such indices, this investing myth needs to be demystified. 

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One may invest in equity markets by following any of the two investment strategies – active investing and passive investing. While active investing requires careful and prudent selection of the stocks in the investment portfolio, passive investing refers to mirroring the benchmark index entirely. 

The fund managers do not have any discretion to invest outside the index constituents or deviate from the index weightage of different index constituents. It helps the investors to eliminate the unsystematic risk from investment plans. Unsystematic risk refers to the risk of making a wrong selection for the investment portfolio. While the investors can't invest directly in the benchmark indices, a low-cost index fund makes it convenient for them to have similar investment exposure. 

Index funds aim to create an investment portfolio similar to the constitution of a benchmark index. As such, the weightage of the index constituents is the same in the investment portfolio as it is in the index itself. The fund manager tracks the indices' changes and replicates the same in the fund portfolio. Since the index fund's constitution mirrors the benchmark index, the investors may generate similar returns given by the benchmark indices through index funds. 

Index funds may track different benchmark indices, including but not limited to NSE Nifty 50, S&P BSE Sensex, Nifty Midcap100, etc. Since such funds adopt a passive investment strategy to maintain the investment portfolio, the fund management charges are lower than active funds. Thus, index funds emerge as a low-cost investment option for the investors to have a broader investment exposure of benchmark indices. 

Returns from low-cost index funds

Index funds tend to have zero alpha, as there is no deviation within the investment portfolio against the index constitution. Time-tested methodologies used to construct the benchmark indices, the investors may find themselves comfortable to emulate the benchmark returns, instead of aiming to outperform them. For example, if S&P BSE Sensex has generated 10% returns during the past year, an index fund tracking it will tend to generate similar returns, subject to tracking error. 

Investing in low-cost index funds

The investing process for index funds is similar to that for investing in other mutual fund schemes. Thus, the investors may invest through physical submission of the application forms or by undertaking the transaction online through the website/ mobile apps. 

Taxation of Index Funds

Since index funds replicate the benchmark indices, the taxation will depend upon the index composition. The index funds replicating the equity indices are taxed as equity-oriented funds. Thus, the gains from investments in index funds held for less than 12 months are classified as Short-Term Capital Gains (STCG) and taxed at a special rate of 15% (plus applicable Cess and surcharge). 

However, suppose such investment has been held for 12 months or more. In that case, the investors must pay tax at 10% (plus applicable Cess and surcharge) after availing an exemption of Rs. 1 lakh in a year towards LTCG on equity shares and equity funds taken together. 

Low-cost index funds are an attractive investment option for the investors who seek investment exposure towards the benchmark indices, instead of relying upon the fund managers' selection of stocks. 

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