Basics of Index Fund Investing in India 2021

Basics of Index Fund Investing in India

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Investing in financial markets can be a tough and time-consuming job which requires large amounts of investment , long hours of research and high amounts of risk-taking and even then your portfolio can end up negative just because of something unforeseeable happening like a pandemic which can be very frustrating.

An Index Fund is one such instrument that removes these uncertainties without really focussing on research which is why leaving the Basics of Index Fund Investing in India becomes very important for the modern-day investor.


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What is an Index Fund?

Index Fund is a fund that invests in stocks which imitate a stock market index like Sensex or Nifty. It is very similar to a mutual fund in the way that it is open for all retail investors big or small to invest their money into these funds, also allowing investors to invest by making small monthly payments in the form of SIPs.

An Index Fund can provide investors exposure to broad markets at low operating costs and lower portfolio turnover. Historically, Index Funds were considered as ideal for retirement planning for people to create a haven of savings for the later years of their life. Instead of picking up individual stocks to invest in which can be a risky proposition.

However, there has been a significant shift in the markets for Index funds with many new investors also choosing them as their preferred investment vehicle of choice given the low expertise required to invest in Index funds coupled with low costs. This is one of the major reasons why beginner investors should also know the Basics of Index Fund Investing in India.

How do Index Funds Work?

Index Funds is a diversified equity fund that is designed to mirror a stock index but with the difference that the fund manager has no say on the stock selection. At all times, the fund manager needs to ensure that the Index Fund imitates the stock index leading to high correlation between the funds NAV with that of the stock index. 

This means that if the Stock Index rises by 10% for a year , the Index Funds returns should be roughly about the same value. However, if the Stock Index drops by 10%, the Fund will also lose money by the same percentage.

Objective of an Index Fund

To generate returns that is commensurate with the performance of the index that it tracks, subject to tracking errors. Generally, the index fund allocates 95-100 per cent of the corpus into equity securities covered by the index, while 5 per cent may be kept in cash and money market instruments. If your goal is to invest for the long-term, that too in the large-cap index stocks and generate a return similar to that of the market, it would probably match the index fund’s objective.

Index Funds v Actively Managed Funds

Since most Index Funds need to track a stock index, they don’t require a lot of management, and a fund manager does not have to keep giving special attention to this fund meaning it is a passively managed fund while on the other hand, an equity fund attempts to outperform its peers and the stock market in general. Hence, an equity fund is actively managed and requires more efforts in terms of research, strategy, etc. from the fund manager which is why they have higher costs associated with them as compared to Index funds.

Low Costs

Since the Index Funds are simply tracking a stock index, the fund manager simply needs to build a portfolio of stocks that replicate the underlying Index. This does not require the services of large teams of research analysts or sales teams as the holdings of an Index Fund are hardly ever liquidated or the stock selection changing over time.

On the other hand, actively managed funds require more work in researching new stocks and also their buying and selling activities also increase in order to gain higher returns causing the cost of doing business to shoot up.

The extra costs of fund management are reflected in the fund’s expense ratio and get passed on to investors. As a result, cheap index funds often cost less than a percent—0.2%-0.5% is typical, with some firms offering even lower expense ratios of 0.05% or less—compared to the much higher fees actively managed funds command, typically 1% to 2.5%.

Expense ratios directly impact the overall performance of a fund. Actively managed funds, with their often-higher expense ratios, are automatically at a disadvantage to index funds, and struggle to keep up with their benchmarks in terms of overall return.

Should You Invest in Index Funds?

Investors who want to invest for the long term and are sceptical about the role of fund managers should consider investing in Index Funds.Also, given that actively managed funds are more volatile and risky it makes more sense for risk averse investors to choose index funds given they are less risk and inherently more diversified. Investors should also consider the low expense ratio of Index Funds as compared to other funds before investing.

Advantages

Investors should also consider the fact that most Indexes give returns in the range of 10%-15% which is significantly higher than inflation without taking much risk or having to rely on a fund manager’s expertise. 

There is always a chance that your fund manager may end up picking up a few underperforming stocks or the style of the fund could change after he quits. Such situations could impact actively managed funds. Index funds cut out this risk by passively investing only in securities that represent a particular index.

Disadvantages

On the flip side, funds actively managed by Fund managers tend to perform better than Index funds historically and will continue to do so in the future. One of the main reasons is that fund managers are actively buying securities which are profitable and selling those which might lose while index funds tend to move with the market and will go down in value if the market or the index moves down.

Also fund Managers are more actively researching and analyzing companies, meeting with board members and understanding their expectations. They also have a lot of experience of managing funds and follow a structured approach to investing.

Best Index Funds to Invest in India

There are plenty of Index Funds out there for investors to choose from but investors should look at the return as well as the cost of investing in these funds before making the investment in any index fund. Here is a list of Index Funds which can provide a good return for investors:

Fund NameReturn(p.a)Expense RatioNAV
Nippon India Index Sensex16.64%0.15%₹ 26.49
HDFC Index Sensex Fund16.62%0.20%₹ 466.84
IDFC Nifty Fund16.62%0.16%₹ 32.71
UTI Nifty Index Fund16.47%0.19%₹ 103.02
HDFC Index Fund Nifty 50 Plan16.37%0.20%₹ 143.54

Tracking Error

While looking and comparing various index funds, an important element is the ‘tracking error’ of such funds. Even though index funds aim to mirror market movement, the returns are actually marginally lower than the index they track. This variation is termed as ‘tracking error’. The factors that affect tracking error are inflows/outflows in the fund, corporate actions, change of index constituents and the level of cash maintained in the fund for liquidity purposes.The lower the tracking error, the better is the fund.

Conclusion

Investment in Index Funds should be like investing in any other investment vehicle by researching the risk and returns offered by the investment properly. Investors should also be aware of the costs associated with investing and the tax implications of investing in these instruments.

As far as tax implications on index funds go, being equity mutual funds they are subject to dividend distribution and capital gains tax. A dividend distribution tax of 10% is levied whenever a fund house makes a dividend payment. Whenever an investor redeems the units of an index fund, you earn capital gains – which are taxable. The rate of tax depends on the holding period – the period for which you were invested in the fund.

Hence, an investor should keep in mind all the above factors before investing in Index Funds.

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