What is Index Fund, Benefits, Taxes & How to Invest in Index Funds

Nowadays Mutual funds have become very popular in today’s time for investment. As a mutual fund investor, you should be aware of all types of mutual funds. So that you can choose the best option to achieve your goals.

One of these types of mutual funds is an index fund. Let me tell you that Index funds are the favourite investment option of Mr Warren Buffett.

There is always risk involved in Equity Mutual Funds. Hence investors always try to diversify their portfolios by investing in different types of funds. Diversifying the portfolio also reduces the amount of risk.

Today we will talk about index funds in detail. Which will include What are Index Funds (Index Fund Meaning), How Index Funds Work and Complete Information about Index Funds. After reading this article you will be able to decide whether you want to invest in an index fund or not.

What are Index Funds?

Before knowing what index funds are, it is necessary to go through indexes. An index is an indicator to measure the performance of a stock or group of assets. An index is made up of the best stocks from many different sectors.

The index is used by investors as a benchmark. Nifty and Sensex are the two main indices in the Indian stock market. Like Nifty is made up of the 50 largest companies of the country on the basis of market capitalization. Same Sensex is made up of the 30 largest companies of the country on the basis of market capitalization.

As the name index fund suggests, these mutual funds to invest in various stocks which belong to a particular index like Nifty, Sensex, Bank Nifty etc. Index funds are passively managed by its fund manager. This means that fund managers invest only in those stocks which are in the index that the fund follows.

The fund manager invests in the same proportion as the stocks in the index. For example, if Reliance Industries Ltd share in Nifty is 10%, then the fund manager will invest a total of 10% of the fund in Reliance Industries Ltd. Thus the fund manager does not make any significant changes in the stock structure.

Index funds provide similar returns to tracked index funds. Index funds do not attempt to outperform an index or benchmark. Thus, they help the investor to manage risk with a balanced portfolio.

How do Index Funds Work

As index funds are exactly the same as its index. You can also think of an index mutual fund as a short form of an index fund that tracks it. For example, if there is an index fund of Nifty 50, then this index mutual fund will also consist of 50 stocks like Nifty.

Being passively managed, the fund manager buys and sells stocks as per the index. If the index has given a return of 10% in a year, then its index fund will also give you a return of about 10%.

Index funds do not have a large team to conduct research and analysis like the active Mutual Funds. Active Mutual Funds have a fully backed team. The fund managers of Active Fund constantly strive to beat its benchmark.

Who Should Invest in Index Funds?

After knowing what index funds are, the next question comes whether you should also invest in index funds? To know the answer, let me ask you a question –

If an index fund has given a 12% return in the last 5 years (less risky than an active fund). The same active mutual fund has given a 14% return in the last 5 years (higher risky than index fund).

Now, which one will you choose between these two funds? If you can compromise on small returns with little risk, then you can invest in index funds. Otherwise, you can choose an Active Fund. Let us understand it in detail.

As index funds follow the market index, their returns are also almost equal to that of the index. That is why such investors who want returns similar to the index can also invest in index funds without the risk of active funds. Thus, whether to invest in these funds or not entirely depends on your risk appetite and your investment goals.

For example, if you want to take advantage of the returns of equity but do not want to take the risk of an active fund, then you can invest in an index fund that can give you good returns in equity.

In Active Funds, the fund composition is constantly changed by the fund manager, which leads to a higher degree of risk. If you are an investor who wants to get more returns than the market returns and is ready to take more risk then you can invest in Active Funds. But in this, you have to keep the investment period at least 5 to 7 years so that you can get the desired returns.

Do Index funds have fees?

If you want to invest in index funds, then you do not have to pay anything to start it. But there is definitely an Exit load in the Index Fund. Exit load means that if you sell your Index Fund investment within one year from the date of investment, then you have to pay Exit load. It is usually around 1%.

If we talk about the expense ratio, then index funds are passively managed due to which the expense ratio in them is very low, 0.1% or less than that.

How to Invest in Index Funds

You can invest in an Index Fund through both SIP or Lump Sum options. You can invest in index funds online, offline or through an agent.

You can buy index funds online by visiting the official website of the index fund of your choice. For example, if you want to invest in a UTI Nifty Index Fund, then you can buy an Index Fund by visiting their website https://www.utimf.com. Apart from this, you can also invest through mobile apps like Grow, Kuvera, ET Money etc.

In offline mode, you can invest by visiting the mutual fund office. But if you are from a small place then you might not find your favourite AMC office in your city. In this case, you can invest through an agent.

But, my advice to you is that you should always invest in mutual fund direct plans.

Taxation of Index Funds

Like all mutual funds, you have to pay some tax on your gains in index funds.

If you sell the equity index fund before one year, then you have to pay STCG tax at the rate of 15%.

Same if you sell equity index funds after one year then you will have to pay LTCG tax at the rate of 10%. It is worth noting here that you have to pay LTCG tax only on capital gains above one lakh.

Dividend Distribution Tax – Whenever the fund house pays you dividends, it pays you after deducting 10% TDS.

Types of Index Funds

If you are willing to invest in index funds, then you will find many types of index funds.

1. Broad Market Index Fund – This type of index is made up of stocks from many different sectors. In this, you get a variety of different types of stocks. These types of index funds have low expense ratios.

2. International Index Fund – This type of index fund is not tied to any geographical boundary. By investing in these index funds, you can give your portfolio exposure to foreign funds.

3. Bond Based Index Fund – By investing in this type of index fund, you can keep a combination of short term, medium-term and long term portfolios.

What are the things to keep in mind while investing in index funds?

There are a few things you have to keep in mind while investing in Index Fund Mutual Funds. If you keep these things in mind, then your chances of making mistakes will be less.

• Returns – Index funds track the performance of their respective index. Thus, the goal of these funds is not to beat any benchmark. Rather, they give the same return as the index. If you are an investor who wants high returns with high risk, then you can invest in active funds. You should not invest in index funds hoping for extraordinary returns.

• Risk – The equity risk in index funds is very low. Index funds are the best option to take advantage of the bull run of the market. If you do not want to take risks at all, then you should invest in index funds.

• Expense Ratio – In index funds, the fund manager does not have to make any extra efforts for stock peaking on his own behalf. For this reason, the expense ratio in index funds is low. So, while investing in index funds, you should pay attention if the fund house is not charging more expense ratio than you. The expense ratio is the fee charged by the fund house for managing your fund.

• Duration of Investment – ​​How the investment will perform in the stock market depends a lot on the duration of the investment. The index can be very volatile in the short term making it riskier. But in the long run, you can easily get the average return. So, if you can invest for a minimum period of 5 years, then you should invest in index funds.

• Financial Goals – Before making any new investment, you should know about your financial goals. If your aim is to make wealth that too with low risk or you are doing retirement planning then you can invest in index funds. If you want to diversify your investments, you can still go for index funds.

Index Fund Pros and Cons

Pros

• It diversifies your portfolio.
• Less risk than active funds.
• Index funds have lower expense ratios as compared to active funds, which can make a huge difference in returns in the long run.
• Helpful in asset creation for long-term investors.
• By investing in index funds, you do not have to worry about any bad stocks in the portfolio as the index automatically excludes the slow performing stocks from the index.
• The qualification of the fund manager has nothing to do with it.
• There is no need to review the Index Fund from time to time.

Cons

• Index funds are more sensitive to market volatility or market crashes.
• Lack of flexibility in index fund portfolios.
• The fund manager himself does not make any extra effort on his part.
• Limited Returns.

Globally, it has been seen in recent times that many fund managers are not even able to beat their benchmark. Therefore, in this uncertain market, index funds come out as the best option.

Top 3 Index Funds in India

Conclusion

In conclusion, index funds are such mutual funds that invest their money only in the stocks of an index. If you want to diversify your portfolio or take less risk as compared to equity active funds, then you can definitely invest in index funds.
Friends, if you liked this information about Index Fund, then you must share this article with your family and friends and if you have any questions then you can ask me through the comment box.