Index Funds - Definition, Risk and Returns | What are Index Mutual Funds

 Index Funds

An important component of a successful investing portfolio is diversification. Investors aim to distribute their money over a variety of asset types, including gold, real estate, debt, and equities. To reduce risks, they work to further diversify even within each asset class. By purchasing shares of firms with various market capitalizations and industries, you may diversify your stock portfolio, a well-known strategy for lowering risks in equity investment. This is where the Index Funds kick in. Here, we'll discuss index funds and their various varieties in India, as well as their advantages and a lot more.

What are Index Funds?

An Index Mutual Fund, as its name implies, makes investments in equities that mimic stock market indices like the NSE Nifty, BSE Sensex, etc. These funds are passively managed, which means the management doesn't alter the portfolio's composition and instead invests in the same assets that are contained in the underlying index in the same proportion. These funds aim to provide returns that are comparable to the index they follow.

Also read:- How To Start An Investment Fund?

How do Index Funds work?

Consider an Index Fund that follows the NSE Nifty Index. There will be 50 equities in this fund's portfolio, all of which will be distributed in the same way. Bonds and equity-related products may both be included in an index. The index fund makes sure to invest in each and every security that the index monitors.

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.

Who should invest in an Index Fund?

Since Index Funds follow a market index, their returns closely resemble those of the index. As a result, these funds are preferred by investors who desire consistent returns and wish to engage in the equity markets without taking on too many risks. In an actively managed fund, the portfolio's composition is altered depending on the fund manager's prediction of the potential performance of the underlying securities. This increases the portfolio's level of risk. Since index funds are passively managed, such risks do not occur. The returns will not, however, be significantly higher than those provided by the index. The best choice for investors looking for greater returns is actively managed Equities Funds.

Factors to consider before investing in Index Funds in India

Before making an index fund investment in India, you should take into account the following significant factors:

Risks and Returns

Index funds are less volatile than actively managed equity funds since they follow a market index and are passively managed. Therefore, there are less hazards. Returns on Index Funds are often strong during market rallies. During a market downturn, it is typically advised to move your assets to actively managed equities funds. Your equity portfolio should ideally contain a well-balanced mix of actively managed funds and index funds. Furthermore, as the index funds try to mimic the index's performance, returns are comparable to the index. Tracking Error, on the other hand, requires your attention. Therefore, you must hunt for an index fund with the lowest tracking error before investing.

Expense Ratio

The expense ratio is a minimal portion of the fund's total assets that the fund house charges for fund management services. The low cost ratio of an index fund is one of its main USPs. There is no need to develop an investment plan or look for stocks to invest in because the fund is passively managed. This lowers the expense ratio by reducing the cost of fund management.

Invest according to your Investment Plan

Investors with a 7-year or longer investment horizon are advised to use Index Funds. It has been noted that these funds undergo short-term swings, but that these changes average out over a longer period of time. You might anticipate returns of between 10 and 12% if you invest over a period of at least seven years. You may link your long-term investing goals with these assets and stay committed for as long as you can.

Tax

Index funds are liable to capital gains tax and dividend distribution tax since they are equity funds, which means they are also subject to both taxes.

Dividend Distribution Tax (DDT)

When a fund house delivers dividends, a 10% DDT is withheld at the source prior to the payment being made.

Capital Gains Tax

An index fund unit redemption results in capital gains, which are taxed. The holding period—the length of time you were invested in the fund—determines the tax rate.

• Your capital gains with a holding duration of up to one year are considered short-term capital gains (STCG), which are subject to a 15% tax.
• Your capital gains with a holding time more than a year are referred to as long-term capital gains (LTCG). Up to Rs. 1 lakh, LTCG is not subject to tax. Any LTCG beyond this threshold is subject to 10% taxation without indexation advantages.