It is stated that ‘there is beauty in simplicity.’ And while it is applicable in our daily lives, it is also applicable in investing. However, the problem is when it comes to investing, people think otherwise. While the new investors run behind the complex structured products, there are many simple ways leading to maximisation of wealth.
Experts suggest, the best and simplest way to start investing is through mutual funds. However, in mutual funds there are various different schemes leading to choice overload for the investors. In such scenarios there is a simple way of investing called index funds. Let us understand what index funds are and why are they so simple and can yet be so impressive?
Actively and passively managed funds
To understand the index funds one must revisit our blog on types of mutual funds, where we had discussed actively managed funds and passively managed funds. For actively managed funds, the fund manager tries to outperform the benchmark indices by actively picking the stocks based on various strategies and based on the investment objectives. For passively managed funds, the fund managers simply track the performance of a benchmark as closely as possible. If the fund manager is investing in an index fund following Nifty 50, all the changes to the index or even the changes in weightage of constituents are closely followed.
The question that arises here is, what is the use of investing if one is not able to outperform the benchmark? Let us understand this with the help of an example. In an investor’s conference where many successful investors were the panelists – one of investors from the audience asked, have you managed to beat the index? He answered, I don’t know and I hardly care. I don’t know if I have outperformed the index or not, but surely I am one of the successful investors to be a part of this eminent panel here. The moral here is that it is not necessary to outperform the index.
Noticeably if we take a look at the performance of Nifty 50 for the past 25 years, the Nifty 50 index has generated a compounded annual growth rate of 11.1 per cent. One must understand that this is higher than the risk free returns. The point here is that index funds deliver. With an asset under management to the tune of Rs. 15,259 crore as on December 2020, it is an important part of the mutual funds segment.
What is an index fund?
An index fund is a mutual fund which invests in securities in the index on which it is based, such as BSE Sensex or S&P CNX Nifty. It invests only in those shares which comprise the selected market index and in exactly the same proportion as the companies as well as the weightage in the index. The value of such index funds varies with the market index. An index fund follows a passive investment strategy, as no effort is made by the fund manager to identify stocks for investment or even for exiting. The fund manager only has to track the index changes on which the mutual fund investment is based. The portfolio of that mutual fund will need to be adjusted if there is any revision in the underlying index. To simplify, the fund manager has to buy stocks which are added to the index and sell stocks which are deleted from the index. Internationally, index funds are very popular. Around one-third of professionally run portfolios in the USA are index funds.
Empirical evidence suggests that active fund managers have not been able to perform well. Only 20–25 per cent of actively managed equity mutual funds out-perform benchmark indices in the long-term. As a result even the risk averse investors such as provident funds and pension funds prefer investment in passively managed funds such as index funds.
As for the Indian markets, the Nifty 50 and the Sensex are the market indexes that index funds may seek to track. A market index like Nifty and Sensex measures the performance of securities to represent a sector of the Indian economy. When it is tough for new investors to choose the right stocks to invest directly, index funds can be considered as an indirect investment option in the market index.
They are passive trackers of the market, thus have a low expense ratio
Protected from poor management by fund managers
An index fund may outperform the market of active funds in the long run.
Underperformance is possible due to factors like fees, expenses, trading costs and in some cases tracking error
The indices are based on the market capitalisation basis and even the weightage increases as the market cap increases.
Expensive valuation of the fund is another major concern
Taxation of Index Funds
As index funds are a class of equity funds, they are essentially taxed like any other equity fund plan. The dividends offered by an index fund are added to one’s overall income and taxed at their income tax slab rate. The rate of taxation of index funds depends on the holding period. Short term capital gains are realised on redeeming one’s units within a holding period of one year. The short term capital gains from the investments in this fund are taxed at 15 per cent if the units are sold within the time period of 1 year from the date of allotment. However, the long term capital gains made on the sale of units priced at over Rs. 1 lakh, within a year from the date of allotment are taxed at 10 per cent without indexation.
Conclusion: Index funds are for those who want to invest for the long term. Further, it usually suits investors having lesser investment domain knowledge and are risk averse. Those who want to keep investing simple and focus on minimising the investment cost can opt for index funds.