Index Funds: How They Work, Advantages, Risks & Who Should Invest
Table of Contents
What Are Index Funds and How Do They Work?
Index Funds are an investment instruments that are based on stock market indices like Sensex or Nifty. These funds are built using a pre-set basket of stocks from different sectors of the economy with predefined weights. The purpose of an Index Fund is to imitate the exact portfolio of the index that it is tracking, i.e., a Sensex Index Fund will hold all the 30 companies that comprise the Sensex in the exact same proportion of weights they have in Sensex.
An Index Fund could be in the form of an ETF (Exchange Traded Fund) or in the form of a Mutual Fund. Each have their own advantages and disadvantages, you can read more about them here. In India, majority of the Index funds primarily focus on the front line indexes like Nifty, Nifty Next50, SENSEX, etc. which are also bench-marked by large cap mutual funds. Of lately, investors now have wider options to invest in Index Funds that track the Mid Cap Indices and Overseas Indices.
How do Index Funds Work?
Index funds are follow passive investment style and do not have any dedicated research team. Since the main objective of the Index Fund is to mimic the underlying Index, there is no frequent buying and selling of shares/bonds. They hold all the companies that form a part of a particular Index in the same proportions and change allocations only when there is a change at the Index level.
However, there can be a small difference between the performance of the Index Fund and the Index it is tracking, known as tracking error. One of the reasons for this tracking error is maintenance of cash portions to ensure liquidity. This passive investment style ensures that the expense incurred in managing the fund is minimal when compared to active funds.
Suitability - Points to consider before investing
Time Horizon
It is important to understand that most Index funds track equity indices and suitable for long term investors. These funds are not suitable for investors who need funds or have goals within the next 5 years. Like all other equity funds, these funds too are volatile in the short term. In the long-term, an index fund may prove to be a good option for wealth creation.
Goal Planning
One needs to follow the three P’s of investing, which are, Plan, Process and Products. Each one of us should have a financial plan in place which defines are goals and investment time horizon. Undergoing a risk profiling exercise helps you define the process; the right asset allocation matrix, the mode of investment, the monthly/one time investment needed achieve your goals etc. Only when the above are defined should you proceed to select the suitable investment instrument. It is saddening to see many people run after the best large cap mutual funds or the best fund of the season only to later realize that the fund was a misfit for their plans.
Tax on index funds in India
Gains made from investments in equity index funds are taxable as a capital gain. These funds are taxed similar to equity funds and the tax rate depends on the holding period of the units of the index funds. Refer here for the ultimate mutual fund taxation guide for tax rules for other types of mutual funds.
Short Term Capital Gains (STCG)
STCG arises when the period of holding of the units is less than 12 months. The tax rate is 15% on the amount of gain earned. For example - If an investor has made a capital gain of ₹50,000 on investment in an equity fund, STCG tax of 15% would be levied if s/he withdraws the amount within one year of investment. The payable tax would be ₹7,500.
Long Term Capital Gains (LTCG)
LTCG arises when investments are held more than 12 months. The tax rate is 10% without the benefit of indexation on the amount of gain earned. The income tax rules provide for tax exemption on ₹ 1 lakh every year. So for a LTCG of ₹1.5 lakh, tax of 10% would be levied on ₹50,000 with tax payable being ₹5,000. This is known as tax gain harvesting, to know more about tax loss harvesting click here.
Advantages of index funds
Low expense ratio
Neither do Index Funds require an active research team nor do they have to active buy and sell securities in their portfolio. This eliminates large management costs. The cost incurred for an Index Fund could be as low as 0.1% when compared to 1% - 2% incurred while managing active funds. This is huge additional return that these funds can generate.
Fund manager risk/bias eliminated
It is known that no one fund stays among the top performers for an extended period of time. All active portfolio managers carry an inherent risk of making an error in judgment due to certain biases or make a decision based on an emotional response. Index funds follow an automated, rule-based investment methodology and eliminate the need to jump/search for the next best fund manager. By sticking to an Index Fund, the investor cab avoid transaction related fees like exit loads and capital gain taxes.
Broad representation & diversification
Investing money in the same stocks and weight-ages as an index makes sure we get a portfolio that is diversified across stocks and sectors. As the major indices are created to be representative of the overall market, they cover all the key sectors of the economy and within each sector, the relevant stocks. This reduces risk as all sectors or stocks seldom go down at the same time.
Disadvantages of index funds
No Concept of Alpha
Though it is difficult and very rare for a fund manager to outperform the stock market consistently, with index funds, the potential to outperform the stock markets is negligible, as they are intended to track the market performance rather than exceed it.
Limited downside protection
Investing in an index fund, such as one that tracks the Nifty50, will give us the upside when the market is doing well, but also leaves us completely vulnerable to the downside.
Inability to take advantage of sudden opportunities
The ongoing slowdown in the auto sector is a brilliant opportunity to add-up on good quality, beaten down stocks within the sector. But an index fund will not be able to exploit the mispricing in the stock markets. Since they have no control on the composition of the portfolio, they can increase or decrease the allocation to a particular stock or sector.
An index fund consists of the most liquid, representative and well governed companies listed on the stock exchange. It is suitable for investors who want to match the returns generated by the Index it tracks and are not looking for outperformance. It is suitable for people who understand that it is difficult to predict the best large cap mutual funds or the best fund in a particular category or segment. It is best suited for people who do not want to churn their portfolio often and want to minimize the perils of active fund management. Book a free consultation call today
