What Are Index Funds? Should You Opt For Them?

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Index funds are mutual fund schemes which track and replicate stock indices and have the same portfolio composition as their underlying index. These are passive funds where the fund manager replicates the benchmark index to build the portfolio.

For instance, if you invest in a Nifty50 index fund, the scheme will automatically invest in 50 stocks which are part of the index in the same proportion. Thus the fund’s performance remains aligned with the index. If the index falls or rises, the fund’s performance also dips or rises proportionately.

Following shrinking alpha or excess returns over the benchmark in the case of actively-managed funds, a trend has emerged – investors are opting for index funds. These funds don’t require active engagement by the fund manager, especially for investment research and picking stocks. As a result, they have a lower expense ratio than actively managed funds.

Should you invest in index funds?

Since active portfolio management is absent in index funds, the risk arising from the fund managers’ calls to beat the benchmark returns is muted. This lowers the fund’s risk, especially in comparison to actively-managed funds. Moreover, investors can predict their returns based on the fund’s long-term benchmark, which hovers around 14-15%. Like other mutual fund schemes, index funds are diversified across securities and sectors, thus offering risk-adjusted returns. The low expense ratio is an added benefit which lets investors acquire more units to boost their investment.

Who should invest in index funds

Offering low-risk equity exposure, index funds are ideal for those new to investing or with a lower risk appetite. They are also suitable for those who are content with the returns offered by the benchmark indices and don’t seek additional returns (alpha) on the investment. Given that the typical market cycle is 6-8 years, it is advisable to stay invested in index funds for a minimum duration of 5-7 years for maximum gains.

Who should avoid index funds?

Investors with high-risk appetites and those seeking returns higher than the broader market should avoid index funds. Given there are funds spread across sectors and stocks in the market can beat the indices’ performance, actively-managed funds may be a more suitable but costlier option.

How are index funds taxed?

Capital gains or dividends in index funds are taxed similarly to other equity-related funds. Yearly dividends over Rs.5000 attract a 10% tax deducted at source (TDS). If investors sell units before they complete one year and book profits, a short-term capital gain (STCG) tax of 15% will be applicable. However, if the held units are sold after a year and profits are booked, a long-term capital gain (LTCG) tax of 10% will be applicable, but only on gains exceeding Rs.1 lakh. No tax is levied on long-term capital gains up to Rs.1 lakh.

Index funds are innovative products which can help you achieve your financial goals. They are suitable for investors of varied ages and risk appetites. New investors or those above 45-50 years looking to lower their dependence on actively-managed funds can benefit from index funds in their portfolio. A combination of index and active funds may help investors achieve their financial goals over time.

The writer is CEO, BankBazaar.com – India’s largest fintech co-brand credit card issuer.