Index Funds - A passive investing way
Index Funds today are a source of investment for investors looking at a long term, less risky form of investment. The success of index funds depends on their low volatility and therefore the choice of the index.
What is an Index Fund?
Many investors are aware of the benefits of diversifying their portfolio across assets. Index funds often catch their eyes in this search as they refer to funds that invest in a broader market index – like the Sensex or the Nifty. All the stocks in these indices will find some representation in their investment portfolio. This theoretically ensures a performance identical to that of the index, which is being tracked. Low expense ratio is its main USP.
Index funds are not actively managed funds, thus incurs low expenses. They do not aim at outperforming the market, but instead to maintain uniformity. They help an investor manage or balance his risks in his investment portfolio.
How do Index Funds Work?
When an index fund tracks a benchmark like the Nifty, its portfolio will have the 50 stocks that comprise Nifty, in the same proportions. An index is a group of securities defining a market segment. These securities can be bond market instruments or equity-oriented instruments like stocks. Some of the most popular indices in India are BSE Sensex and NSE Nifty. Since index funds track a particular index, they fall under passive fund management. The fund manager decides which stocks have to be bought and sold according to the composition of the underlying benchmark. Unlike actively-managed funds, there isn’t a standalone team of research analysts to identify opportunities and select stocks.
While an actively-managed fund strives to beat its benchmark, an index fund’s role is to match its performance to that of its index. Index funds typically deliver returns more or less equal to the benchmark. However, there can be a small difference between fund performance and the index. This is referred to as the tracking error. The fund manager must work towards bringing down the tracking error as much as possible.
In the case of a weighted index, fund managers frequently stabilise the percentage of the securities to ensure making a presence in the benchmark.
Who Should Invest in Index Funds?
Index funds are ideally suited for investors who like to stay put with their investments for the long term. If you have a look at the historical performance of market indices, you would know for sure that they have performed well in the long run despite many instances of short term volatility.Index funds are suited for investors who are looking to build long-term wealth but want to stay away from constant monitoring and juggling their mutual fund portfolio. For example, an index fund can be very much suitable for an investor who wants to build a long term retirement corpus.
Why Should you Invest in Index Funds?
Low Cost: Since index funds are passively managed, the total expense ratio (TER) is very less as compared to the actively managed ones. While an actively managed fund may charge you anything between 1-2% as TER, an index fund would typically charge you between 0.20% to 0.50%. At face value, the cost difference may seem small but in the long run, it can become as large as 15% of your net returns!Diversification: An index fund typically constitutes top companies in terms of market capitalization. It means leading market players across the sectors would be a part of the benchmark index. The auto diversification allows the investor to reduce risk from staying invested in a particular stock or a sector.
No Fund Manager’s Error Scope: Since the allocation of assets in case of index funds is not at the discretion of the fund manager, there is virtually no scope of making losses due to inefficiency in asset allocation or poor management.
Efficient Market Hypothesis: Major economic thinkers have lent their support to the efficient market hypothesis – the theory that no fund manager or investor can outperform the market in the long run. Price anomalies are eventually discovered by competitors and stocks are priced according to their fundamental value. Hence an index fund that represents the market would outperform all active funds in the long run.
NIFTY 50
The NIFTY 50 is a diversified 50 stock index accounting for 13 sectors of the economy. It is used for a variety of purposes such as bench-marking fund portfolios, index based derivatives and index funds.
NIFTY 50 is owned and managed by NSE Indices Limited (formerly known as India Index Services & Products Limited) (NSE Indices). NSE Indices is India's specialised company focused upon the index as a core product.
- The NIFTY 50 Index represents about 66.8% of the free float market capitalization of the stocks listed on NSE as on March 29, 2019.
- The total traded value of NIFTY 50 index constituents for the last six months ending March 2019 is approximately 53.4% of the traded value of all stocks on the NSE.
- Impact cost of the NIFTY 50 for a portfolio size of Rs.50 lakhs is 0.02% for the month March 2019..
- NIFTY 50 is ideal for derivatives trading.
Tax on gains
When you redeem units of index funds, you earn capital gains, which are taxable. The rate of taxation depends on how long you stayed invested in index funds, i.e., the holding period.Capital gains you make during the holding period of up to one year are called short-term capital gains (STCG). STCG is taxed at a rate of 15%. Similarly, capital gains you earn after a holding period of more than one year are called long-term capital gains (LTCG). LTCG over Rs 1 lakh is taxed at 10% without the benefit of indexation.
What are the Disadvantages of Investing in Index Funds?
Market Under-performance: An investor buying into this type of fund gives up the chance of beating the market by picking a good actively managed fund. The efficient market hypothesis has worked in developed economies. In the case of developing countries like India, empirical data suggest that well-managed active funds can beat the returns of passive funds such as index funds.Mature Companies Only: Index companies tend to be mature companies who generally have their best growth years behind them. Investors in such funds do not benefit from the high growth potential of emerging small and midcap companies.
Expensive Valuations: Companies in the index have been discovered by the market. In other words, investors are buying stocks which are already expensive from a valuations perspective.
Few points to consider before investing in Index Funds
- Index Funds definitely the best choice due to its low cost.
- All Index Funds even though replicate their index. There may be certain pointers to decide which fund to choose like an expense ratio, AUM and tracking error.
- Index Funds definitely remove the AMC and Fund Manager risk. However, market risk is always there.
- Index Funds comes with ZERO downside protection. Hence, it is your asset allocation between debt and equity is what a risk managing tool.
- Media and AMCs advertising Index Funds as if they are BEST FOR RISK AVERSE INVESTORS. But do remember that Index Funds never escape from market risk. Hence, asset allocation should be your mantra irrespective of which category of index funds you choose.
https://www1.nseindia.com/products/content/equities/indices/index_funds.htm
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