As humans, we love to get rich and the best way to get rich today is investments. But with investments, there are risks associated. These risks have to be considered while investing and hence the returns have to be evaluated and considered while investing. One popular method of investment today is index funds in India. They today are widely popular and are used by several people and many investors put their trust in index funds in India as a great option to invest.
Going to the diversification, it provides people who are attracted to it and want to invest money in index funds. But if you are a beginner or a person who is not well versed with the knowledge of index funds then before making an investment you might want to know about the benefits of index funds and how they are different from other investment options. So in this article, we will explain to you each and everything that you need to know about index funds in India and hence, it will help you decide if the index funds in Indiaare made for you or not.
- 1 What is an index fund?
- 2 Are index funds in India for you?
- 3 How do index funds in India work?
- 4 Who should invest in index funds in India?
- 5 Low Expense ratio
- 6 1. Less tolerance
- 7 2. Return factor
- 8 3. Investment cost
- 9 4. Investment Horizon
- 10 5. Investment goals
- 11 6. Tax
- 12 1. Underperformance
- 13 2. Mature companies only
- 14 3. Expensive
- 15 Concluding, should you invest in index funds in India?
What is an index fund?
Index funds in India invest in security market indices in the exact securities and exact proportion. Index funds are managed passively. Hence, they do not allow any intervention by the fund manager. They are also known as index tracked mutual funds. As an investor, you might be aware of the benefits of diversifying your portfolio across different assets. When we talk of diversification, index funds in India actually catch the attention of many people.
This is because they refer to indices that invest in a broader market like Nifty or Sensex. There is a benchmark index set and these portfolios follow them whatever be the state of the market. Index funds are generally considered an ideal portfolio when you are holding a retirement account. Warren Buffett, the famous investor has recommended index funds as the most important asset for savings during the sunset years of the life sunset years of your life. This is the reason why picking out individual stocks for investment is less beneficial these funds. The main benefit of an index fund is its low expense ratio. In India, there are two popular indices which are BSE Sensex and NSE Nifty. There can be three kinds of index- inin themex ETF, index mutual funds and3rd is the index fund which maps sectoral indices.
Are index funds in India for you?
You might be in a dilemma as to if an index fund is a right option for you or not. If you are one such person who does not want to take the risk of how a fund manager performs then these are the right option for you.
However, it is advisable to seek help from a financial planner. This way, you can be clear about the investment options if you are not able to understand them. As we talked about less expense ratio, the total expense ratio for index funds is 1% according to SEBI
How do index funds in India work?
Take for example of index funds tracking Nifty. Its portfolio will consist of 50 stocks which comprise only Nifty in the same proportions. An index can be any security that defines the market segment like stocks. As we told they are passively managed, possibly it’s because they track a particular index.
Hence, unlike the actively managed funds, there is no team present of research analysts that identify the possible threats, opportunities and select stocks for you. The main difference between an actively managed fund and index fund is that in an actively managed fund, it tries to beat its own benchmark while index funds try to match its performance to that of its index.
There is a term known as tracking error which refers to the difference between fund performance and index. Hence, the focus is bringing down the tracking error to as little as possible.
Who should invest in index funds in India?
Investing in a mutual fund is a big thing and it is totally your decision and depends upon what kind of risks are you ready to take and your goals. As discussed earlier, these funds are suitable for the people who don’t want to take the risk of a fund manager and expect predictable returns. They do not require extensive tracking. Actively managed funds involve picking securities and timing the market. But you cannot expect a really high return and if you are a person who wishes to get market-beating returns, then you can go for actively managed funds.
When you talk about the long term, actively managed funds perform better than index ones. In the short run, the returns of both of them are equally matched.
Low Expense ratio
Now as we discussed, that index funds have a low cost. What do we actually mean by this? They have low management expense ratio. The expense ratio includes all the expenses which are required in operating like payment to advisors, managers, fees, taxes.
Since index funds track the index, they do not require the services of fund managers. Unlike actively managed funds do not require a big staff, hence, the overall cost is reduced
There are some factors that you need to keep in mind while investing in index funds.
1. Less tolerance
Index funds, as you know, track index and hence they are less prone to risks. In a market full of opportunities and investors, they may prove to be a great option if you want to generate high returns. But whenever the market goes down, you may have to switch to actively managed funds as index funds lose values when there is a downturn in the market.
Hence in your portfolio, you can have a mix of actively managed funds and index funds.
2. Return factor
Unlike actively managed funds, these index funds to not compete against any benchmark, but aim at achieving it again. But as the market is unpredictable, the returns that you get might not be at par with the index and this is when tracking errors creates a problem. Hence, before investing you should track the funds with minimum tracking error. The better, informed and error-free decision you make, the performance of the investment increases.
3. Investment cost
In index funds, the expense ratio of about 0. 5% or even less than that. Actively managed funds have an expense ratio of about 1 to 2.5 %. What creates the difference is that in index funds, the fund manager is not required to create an investment strategy unlike actively managed funds, in which a team of experts is required. Index funds are easier to track as if both funds are cracking the Nifty or Sensex, they will create the same results. The only difference between the two will be the expense ratio.
Expense ratio and returns are inversely proportional I.e. the funds with low expense ratio will generate higher returns on investment.
4. Investment Horizon
People who have long term investment advisors should invest in index funds. To invest,, you must be patient enough to stick for the long-term because, in the short run, the funds experience many fluctuations. But in the long run, you may average out everything.
5. Investment goals
This may be a great option for achieving long term financial goals and for retirement planning. These can generate enough money for you to retire early and follow your passion and do anything in life that you ever wanted.
When you are redeeming the units in an index, you will be getting capital gains and tax is applied to them. The rate of taxation is directly proportional to the time you stayed invested. This is known as the holding period. The gains which make the holding period of up to 1 year are known as short term capital gains. These gains are having a tax rate of 15%.
If the holding period exceeds one year then they are known as long term capital gains. The amount over 1 lakh in long term capital gains is taxed at 10%. The main concept behind an index fund is to replicate the performance of an index. This happens in terms of returns in a minimum amount of money. If you are an investor who would like to stay in the investment market, you will notice that in response, passively managed funds performed better in the long-term.
The main concept behind an index fund is to replicate the performance of an index. This happens in terms of returns in a minimum amount of money. If you are an investor who would like to stay in the investment market, you will notice that in response, passively managed funds performed better in the long-term.
Many major thinkers have supported the fact that no fund Manager or investor can outperform the market in the long run. Hence, an index fund will outperform all the actively-managed funds in the long run.
Let us discuss some disadvantages also of index funds.
In the case of developing countries, like India, actively managed funds tend to beat the returns of index funds.
2. Mature companies only
The index companies are usually major companies who have the best growth years behind them and show investors, who are investing in India, not benefit from the potential of high growth in small companies.
Companies have been already discovered by the market and hence investors are actually buying stocks which are already expensive.
The major difference between Exchange Traded Fund and index fund:
ETFs also track an index like but their units are traded on the stock market. They are not easy to buy from any fund house and cannot be easily sold to a fund house. You need a Demat and trading account to buy units of ETF. It is required that you buy them on the stock exchange. On the other hand, index funds can be bought similarly as any other mutual fund from any fund house and can be easily redeemed from any fund house.
There are many numbers of indices that are tracked by ETF and are not tracked by index funds. For example, Nifty value 20 index
Concluding, should you invest in index funds in India?
Not all investment options are suitable for everyone. Index funds can be a great option owing to the diversification, less expense ratio, etc. But before making an investment, you need to be fully informed and then take a decision.