When one talks of investing in the equity markets, one aspires to be as successful as Warren Buffett. While many consider him to be their investing ‘Guru,’ he calls investing a simple game that advisors have convinced the public is harder than it is. He has recommended investing in low-cost index funds. So what are these index funds?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that purchases all (or a representative sample) of securities in a particular index. The goal is to match the fund performance as closely as the benchmark it tracks. Some of the most common indices are S&P 500, NASDAQ-100, and Russell 2000. Closer home, we have the Nifty 50 index, S&P BSE Sensex, and Nifty-Next 50.
How do index funds work? Consider an index fund that follows the Nifty Index. There will be 50 equities in this fund’s portfolio, all of which will be distributed similarly. Bonds and equity-related products may both be included in an index. The index fund makes sure to invest in each security that the index tracks.
A passively managed index fund attempts to replicate the returns provided by the underlying index, whereas an actively managed mutual fund strives to surpass its underlying benchmark. A passively managed index fund manager may have to reduce the tracking error as much as possible.
Portfolios of index funds only change significantly when their benchmark indices change. The management of a fund that tracks a weighted index may occasionally adjust the percentage of various securities to reflect the weight of those stocks’ participation in the benchmark. A technique called weighting equalizes the impact of each asset in an index or portfolio.
Why would you invest in an index fund?
The primary advantage of investing in an index fund is the lower management expense ratio compared to their actively managed counterparts. (A fund’s expense ratio includes all the operating expenses such as payment to advisors and managers, transaction fees, and accounting fees).
As index fund managers are focused on replicating the benchmark performance, they do not need to hire research analysts to assist in the stock selection process. As trading is also less frequent, the transaction fees and commission expenses are also lower.
Are there any risks to investing in an index fund?
Yes, like any investment, index funds are also subject to certain risks. First, the index fund will be subject to the same risks as the securities in the index it tracks. Second, there is less flexibility to react to price declines in the securities in the index vis-à-vis a non-index fund.
If the fund does not exactly follow the index, there can also be a tracking error. The performance of an index fund, for example, may not perform as well as the index if it only holds a portion of the securities in the market index.
So, who should consider investing in an index fund?
Now that we know what index funds are, and the pros and cons of investing in index funds, we wonder if index fund investing is right for us.
As index funds track a market index, the returns are approximately like those offered by the index. Hence, investors who prefer predictable returns and want to invest in the equity markets without taking a lot of risks prefer index funds.
The Taxation Aspect
Being equity funds, index funds are subject to dividend distribution tax and capital gains tax. Redemption of index fund units may lead to taxable capital gains. The capital gains earned in the case of a holding period of less than one year is short-term capital gain (STCG) which is taxed at 15%. In case of a holding period of more than one year, an investor would be liable to pay long-term capital gain tax (LTCG). LTCG up to Rs 1 lakh is not taxable, and the amount above that is taxed at the rate of 10% without indexation benefits.
Disclaimer: “The views expressed are for information purposes only. The information provided herein should not be considered as investment advice or research recommendation. The users should rely on their own research and analysis and should consult their own investment advisors to determine the merit, risks, and suitability of the information provided.”