Best Index Funds- Features, Advantages, Taxation

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SEBI defines Index funds as open-ended schemes that replicate or track the market’s index. As per the guidelines, the minimum investment in securities of a particular index that is being replicated or tracked must be 95% of the total assets.

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Understanding Index Funds

An index fund can be explained as a type of mutual fund which constructs its portfolio by tracking the composition of a standard market index such as the NIFTY 50 or the Sensex. The fund invests in both, the stocks which constitute the benchmark index and in the amount that is present in the index.

Let’s take, for example, if Reliance Industries Limited (RIL) and Tata Consultancy Services (TCS), among all the constituents of Nifty 50, hold 10% and 5% weightage respectively, then the Index fund benchmarking, Nifty 50 would allocate 10% of its asset to RIL and 5% of the portfolio to TCS.

It must be noted that the major idea behind an index fund is to replicate the performance of an index in terms of returns at a minimal cost. Index funds are also called passive funds as these do not require a high level of active management of the fund. Naturally, the expense ratio and other fees of index funds are lower than the actively managed funds, which makes them cost-efficient.

Features of Index Funds

• Index funds can be taken as a long-term, less risky form of investment
• The success of these funds predominantly depends on the choice of index and their low volatility
• Since these funds create a portfolio that almost replicates the chosen index, the returns offered by these funds are also similar to that of the index
• Given the dependence of these funds on the performance of an index, index funds are passively managed; hence, these funds are not meant to outperform the market but instead mimic the index’s performance
• Due to the passive management of these funds, they involve lesser expense ratio and thus, low expenses
• Index funds are, additionally, known to provide broad market exposure and low portfolio turnover to the investors

Advantages

• 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, the difference can be as large as 15% of your net returns.
• Diversification: An index fund typically constitutes of 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 errors: 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 the investor incurring 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.

Also Read: Best Index Funds to Invest in 2020

Who should invest

• Index funds are ideally suited for investors who like to stay put with their investments for the long term
• You are advised to invest in index funds if you are willing to stay away from constant monitoring and juggling of your mutual fund portfolio
• You may invest in these funds if you are looking to gain from the mirror returns of SENSEX, NIFTY, etc.
• These funds will be suitable for you if you wish to get better returns than Fixed Deposits over long term
• You are suggested to invest in index funds only if you are looking for a buy-&-hold over long term of 5 years or more
• If you are risk-averse investor, you may consider investing in index funds since these are known to be less prone to equity-related volatility and risks

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Taxation on Index Funds

The short term capital gains from the investments in this fund are taxed at 15% 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% without indexation.

For example-

If an investor has made a capital gain of ₹50,000 on investment in an equity fund, Short Term Capital Gains Tax of 15% would be levied if s/he withdraws the amount within one year of investment. The payable tax would be ₹7,500.

Also, if an investor has made a capital gain of ₹1.5 lakh on investment in an equity fund, and withdraws the amount after 1 year of investment, Long Term Capital Gains Tax of 10% would be levied on ₹50,000. ₹1Lakh is exempted from taxation. The payable tax would be ₹50,00.

Things to be considered

• Investments made in Index funds may lose the chance of beating the market by picking a good actively managed fund
• In the case of the Indian stock market, data suggests that well-managed active funds can beat the returns of passive funds such as index funds
• Index funds tend to invest only in mature companies that generally have their best growth years behind them. Investors of such funds do not benefit from the high growth potential of emerging small and midcap companies
• Companies in the index have already been discovered by the market, which implies that the investors of these funds are eventually buying stocks which are already expensive from the valuations perspective
• While investing in index funds, investors must be careful with the tracking error of the fund. Tracking error is basically the difference between the index fund return and its benchmark return. The lower the tracking error, the better the fund’s performance

How to Invest in Index Funds

You can invest in index funds through either of the following ways-

• Offline mode of investing– If you are not confident of your knowledge, you may choose to invest through a broker. However, investing in a fund through a broker will make you eligible for investments through regular plans that offer different returns and varied expenses in investment. If you wish to invest in the fund independently, you must visit the nearest branch of the AMC of your fund. Don’t forget to carry the following documents-
  • Identity Proof (Aadhar Card)
  • Canceled cheque
  • Passport size photos (around 4-5)
  • PAN Card
  • KYC documents (for KYC verification)

• Online mode of investing– If you do not wish to add on to your expense of commissions or brokerage, you may visit online investment platforms such as Paisabazaar.com wherein you can choose from and compare more than 1,700 funds- all in one place, instead of following the long procedure of visiting the website of each AMC and then choosing from them. Here, you can select the fund in which you want to invest, look at the details and compare similar schemes as well as use SIP Calculator or Lumpsum Calculator to estimate the future value of your investment

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Also Know What is Difference Between ETF vs Index Funds

Best Index Funds to Invest 

Given the ideal investment horizon of 5 years, here is a list of 5 best index funds that you may invest in-

Data as on 27 February 2020; Source: Value Research