Things to Consider before Investing in Index Funds!

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Passive investing has been getting a lot of traction from retail investors in India. The total AUM of passive mutual funds has reached Rs 1.85 lakh crore. This is an increase of more than Rs 80,000 crore in the last one year. This surge is attributed to several advantages of passive funds. It can also be attributed to the recent widespread awareness about passive investing, notably the cost-effectiveness. Before we delve into the various aspects of index passive funds, it is essential to grasp the fundamental concepts of what an Index is and the nature of index funds.

What is an Index?

An Index represents a benchmark or a specific market index. It is used in guiding a passive fund’s investment approach. Indices vary, encompassing broader market benchmarks like the Nifty 500 index. There are market-cap-specific indices as well such as Nifty50, Nifty Midcap 150, and so forth. Some indices are tailored towards sectors or themes, including Technology, Healthcare, etc. Contrary to common misconception, indices are not solely focused on equities. There are fixed income indices that track the performance of specific groups of fixed-income securities, such as government or corporate bonds. A prominent example of this is the Bharat Bond Index.

What are Index Funds?

Index funds are passive funds. Just like ETFs, these funds aim to replicate a specific benchmark like Nifty 100 Index or Sensex, inter alias. Rather than employing active management strategies to pick and choose individual stocks, index funds passively track a chosen index. Albeit, unlike ETFs, Index Funds have a structure of a traditional mutual fund. These funds are bought or sold directly by the AMC at the Net asset value (NAV) of the fund.

Lower Cost of Index Funds:

Index funds have lower costs because these don’t involve actively picking of stocks. The fund manager’s job is simply to copy the benchmark’s composition and performance. This means fund managers are not required to make any decision. This cuts down the cost of running the fund.

Types of Index Funds:

There are various types of Index Funds, each designed to track a different index. Here are few major types of Index Funds:

1. Broader Market Index Funds: These funds mirror the performance of broader market indices, like the Nifty 500.

2. Sectoral or Thematic Index Funds: Some funds follow indices which are focused on specific sectors like Banking or other types of themes like international investing.

3. Fixed Income Index Funds: Debt Index Funds in India track a particular Fixed Income Index and do risk replication. These might not have the exact composition due to the ill-liquidity of the India’s Debt Market, but such funds match the same duration and credit profile as the benchmark index.

4. Commodity Index Funds: This is the smallest category of Index funds in India. It aims to track commodity indices such as Gold and Silver.

Things to Consider before Investing in a Low Cost Index Fund:

1. Riskiness of Funds: Many investors perceive Index funds as less risky than the actively managed funds. However, it is essential to note that while these funds don’t carry immediate risks, but inherent risks associated with the asset class do exist. Within mutual funds, Small cap funds pose the highest risk, followed by Mid and Large cap funds. Therefore, it is crucial for investors to consider these factors before they make investment decisions.

2. Fund Suitability: Like Mutual Funds, the appropriateness of funds relies on the underlying composition. Equity funds are better suited for aggressive investors, while debt-oriented funds are more appropriate for conservative investors. To lessen the impact of market swings, investors can consider Systematic Investment Plans (SIPs) to build long-term wealth.

3. Tracking Error: The tracking error in Index funds refers to the divergence or difference in performance between the Index fund and the benchmark Index. Ideally, funds with lower tracking error should be preferred by investors.

4. Taxation: In terms of taxation, Index Funds are treated similarly to other Mutual Funds. Equity Index Funds are taxed at 15% for Short-Term Capital Gains (STCG) and at 10% for Long-Term Capital Gains (LTCG) that exceed Rs. 1 lakh. This is obviously after you hold the investment for over a year in any financial year.

5. Expense Ratio: Factors like passive management, lower turnover, reduced research costs, and potential economies of scale enables index funds to maintain cost efficiency.

Conclusion

The growing popularity of index funds signifies a notable shift in how investors approach the domestic market nowadays. Factors like lower costs and diverse available index have made these funds an attractive choice for many. Furthermore, the simplicity of passive management aligns well with the investment strategies of long-term investors. The utilization of strategies like Systematic Investment Plans (SIP) and Systematic Transfer Plans (STP) adds to the versatility of these funds. This gives investors a disciplined and phased approach of wealth creation. This increasing awareness and the expanding range of options underline the enduring relevance of index funds. This reflects a growing trend towards a more efficient, disciplined, and cost-effective investment approach.