Some investors' first acquaintance with the equity markets may be through benchmark indices, such as NSE Nifty50 and BSE Sensex. Such indices are an indicator of the broader markets. The common myth, that equity investing is investing directly into such indices, needs to be demystified.
One may invest in equity markets by following any of the two investment strategies – active investing and passive investing. While active investing requires careful and prudent selection of the stocks in the investment portfolio, passive investing refers to mirroring the benchmark index entirely.
Passive fund managersdo not have any discretion to invest outside the index constituents or deviate from the index weightage of different index constituents. Therefore, it helps investors eliminate the unsystematic risk from investment plans. Unsystematic risk refers to the chance of making a wrong selection for the investment portfolio. While investors can't invest directly in the benchmark indices, an index fund makes it convenient for them to have similar investment exposure.
What is an index fund?
Index funds are a specific category of mutual fundswhich aim to replicate an underlying index. As such, they create an investment portfolio similar to the constitution of a benchmark index. The weightage of the index constituents is kept the same in the investment portfolio. The fund manager tracks the indices' changes and replicates the same in the fund portfolio. Since the index fund's constitution mirrors the benchmark index, the investors may enjoy similar returns given by the benchmark indices through index funds.
Index funds may track different benchmark indices, including but not limited to NSE Nifty 50, S&P BSE Sensex, Nifty Midcap100, etc.
What is a low-cost index fund?
Since index funds adopt a passive investment strategy to maintain the investment portfolio, the fund management charges are lower than active funds. Thus, index funds emerge as a low-cost investment option for the investors to have broader investment exposure to benchmark indices. Low-cost index funds have low expense ratios compared to other funds. The expense ratio may be as low as 0.06%.
Returns from low-cost index funds
Index funds tend to have zero alpha, as there is minimal deviation within the investment portfolio against the index constitution. Since time-tested methodologies are used to construct the benchmark indices, the investors may find themselves comfortable emulating benchmark returns instead of aiming to outperform them. For example, if S&P BSE Sensex has generated 10% returns during the past year, an index fund tracking it will tend to generate similar returns, subject to tracking error.
Investing in low-cost index funds
The investing process for low-cost index funds is similar to investing in other mutual fund schemes. As such, one can visit any of the Official Points of Acceptance (POA) to submit the duly filled application form along with a crossed cheque in favour of the mutual fund house and the specified scheme. One can also undertake an investment transaction digitally in index funds through the website/ mobile apps of the mutual fund house or the Registrar & Transfer Agent (R&TA). Online transactions can be undertaken once KYC verification for the investor's PAN is in place. Further, once the investment has been processed, there is no differentiation between the mutual funds based on the mode of investment. The same NAV is applied for the mutual fund units, whether purchased digitally or physically.
What are the different indices?
Index funds may track different benchmark indices, including but not limited to NSE Nifty 50, S&P BSE Sensex, Nifty Midcap100, etc.
What are the different indices?
Index funds may track different benchmark indices, including but not limited to NSE Nifty 50, S&P BSE Sensex, Nifty Midcap100, etc.
Low-cost index funds vs. ETFs vs. other mutual funds
Here is a brief comparison of these three investment options on different parameters:
Investment strategy
Since both index funds and ETFs are passive investment products, index funds are akin to ETFs in terms of the investment strategy of tracking an underlying index. However, actively managed mutual funds follow an active investment strategy wherein the fund manager decides which stocks to invest in.
Investment risk
When it comes to investing, investment risks are classified into systematic and unsystematic risks. Systematic risks are inherent to investing and attributable to risk of adverse movements in valuation due to macroeconomic changes. In contrast, unsystematic risks refer to the risk of fund manager making a wrong investment decision leading to lower returns. Index funds and ETFs adopt passive investment strategies wherein there is no discretion for the fund manager to invest beyond the underlying index composition. As such, unsystematic risks are automatically managed with index funds and ETFs. In contrast, actively managed mutual funds carry both systematic and unsystematic risks.
Liquidity
Transactions in index funds and actively managed mutual funds happen through the fund house. As such, there are no liquidity concerns while investing in index funds and actively managed mutual funds. In contrast, transactions in ETFs are subject to demand-supply of ETF units on stock exchanges.
Things to consider when buying an index fund
While there is no differentiation in the investment portfolio amongst different index funds tracking the same index, one may consider the following things when buying an index fund:
Total Expense Ratio (TER)
Since expense ratio is charged to the scheme, the returns are directly impacted by the TER. In case of two index funds tracking the same underlying index, the returns of the fund with higher TER may be lower.
Tracking Error (TE)
Tracking Error refers to the divergence between the portfolio and underlying index. This may result from the time difference between when the changes happen in the underlying index and when they’re actually implemented in the investment portfolio. Higher the tracking error of the index fund, higher would be the variance between the fund's performance and the underlying index’s performance.
Taxation of index funds
Since index funds replicate the benchmark indices, the taxation will depend upon the index composition. Index funds replicating equity indices are taxed as equity-oriented funds. Thus, the gains from investments in index funds held for less than 12 months are classified as Short-Term Capital Gains (STCG) and taxed at a special rate of 15% (plus applicable Cess and surcharge).
However, suppose such investment has been held for 12 months or more. In that case, the investors must pay tax at 10% (plus applicable cess and surcharge) after availing an exemption of Rs. 1 lakh in a year towards LTCG on equity shares and equity funds taken together.
In case the index funds are tracking a debt index, like State Development Loans (SDL) Index, etc., the specified cut-off period for classification as LTCG and STCG is 36 months. If the investment has been held for less than 36 months, the gains are classified as STCG and taxed at the regular tax rates applicable to the investor. However, in case mutual fund units have been held for 36 months or more, LTCG on such debt fund units is taxed at 20% (plus applicable cess and surcharge) with the benefit of indexation.
Low-cost index funds are an attractive investment option for investors who seek investment exposure towards the benchmark indices, instead of relying upon the fund managers' selection of stocks.
