Are Index Funds Suitable for Retail Investors?
Making a direct investment in benchmark indices can be the most straightforward investing strategy for the investors, as they can have an investment exposure towards a diversified basket of stocks. However, investing in benchmark indices directly is not possible, as such indices are not tradeable security.
One needs to maintain a similar portfolio composition as that of the index to fulfil this investment objective, which may not be convenient for the retail investors. This is because the index constituents and weights keep on changing with time. Such monitoring and subsequent rebalancing require reasonable time from the investors and entail high capital requirements. Index funds emerge as a convenient investment option of the investors willing to have similar investment exposure.
Investment exposure for Benchmark Indices
Index funds adopt a passive investment strategy, aiming to replicate the benchmark indices within their investment portfolio. As per the SEBI guidelines for classification of mutual fund schemes, an index fund must have at least 95% investment in the securities of the particular index being tracked by the fund.
While the fund manager aims to mimic the benchmark indices, there might be a time lag when the changes happen in the index composition, and when the changes are replicated within the fund portfolio. This time lag may lead to tracking error, reflecting how efficiently the fund manager is tracking the benchmark index.
A fund manager will always aim for a low tracking error so that the ultimate investment objective to invest in index funds is achieved for the investors. Such funds will tend to have zero alpha, i.e., generating similar returns as generated by the benchmark indices. When the markets tend to be volatile, and alpha generation becomes difficult, investing in index funds can be a better investment option.
Lower Expense Ratios
As per the SEBI guidelines, the Total Expense Ratio (TER) ceilings, including investment and advisory fees, for index funds cannot exceed 1% of the total net assets. In contrast, the TER for other schemes may extend up to 2.25% depending upon the AUM of the scheme. Owing to the lower fund management charges due to the passive investing strategy, index funds tend to have a lower cost structure for the retail investors against the other mutual fund schemes.
Further, with the evolving financial markets and emerging preferences to invest in passive investment products, the expense ratios for index funds/ ETFs have been steadily reducing. The average expense ratios for direct plans in such funds have declined from 0.81% in March 2015 to 0.14% in March 2020.
Elimination of Unsystematic Risk
Besides providing investment exposure towards benchmark indices at a lower cost, such funds also mitigate the investors' unsystematic risk. Investment risks can be classified into two broad categories – systematic risk and unsystematic risk.
Systematic risk involves the risk of the macroeconomic changes impacting the investment portfolio and thus tends to be beyond the fund manager's control. In contrast, unsystematic risk refers to the risk of making the wrong investment decision for the investment portfolio. It might occur due to the errors in judging the future market conditions etc.
When one adopts a passive investing strategy, there is no discretion with the fund manager to invest beyond the index constituents or deviate from the index weightages. As such, investors can eliminate the unsystematic risk of investing in equity markets through index funds.
The gains from units in index funds tracking equity indices are categorised into Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG) based on the holding period for such investments. The cut-off period for such categorisation is 12 months for equity funds.
Depending upon whether the holding period of such units is less than 12 months or higher. While STCG is taxed at 15%, LTCG is taxed at 10% post Rs. 1 lakh exemption towards LTCG from equity shares and equity funds, including index funds, taken together.
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.