What is an Index Fund & How to Select Index Fund

It is vital to diversify your investment portfolio. You can do so by investing money across various asset classes, such as real estate, debt, equity, gold, etc. Furthermore, investors try to diversify their investments within each asset class to minimize risks and maximize returns.

One of the methods to reduce risk is by diversifying your equity portfolio with investments in shares of companies from different sectors and market capitalizations. This method is known as equity investing. Index funds play an essential role here.

What are index funds?

An index fund invests in stocks that imitate the portfolio of an index. They are attractive for investors as they intend to replicate the performance of their underlying index like the Nifty or the Sensex. The management of these stocks is passive, which means that the investment is in the same securities as the underlying index. The proportion is also the same, and there is no change in the portfolio composition. Index funds seek to offer returns similar to the index they track.

Things to consider when selecting an index fund

After you have allocated money to invest in index funds, here’s what you need to keep in mind:

1. Expense ratio

Most index funds charge an annual fee. That fee is the expense ratio and covers the operating expenses. While index funds map the performance and composition of existing indexes, there are costs for buying and selling investments held by an investor. The expense ratio is not transparent as your regular fund statements don’t have any line item indicating how much the fee costs you. Instead, the fee automatically deducts your returns as a percentage of the fund assets.

Fees are everything when it comes to indexing. After selecting an investment category to use for indexing, you must search for the fund with the lowest expense ratio.

2. Risks and returns

Index funds emanate the performance of a market index, and their management is passive. They are less volatile than actively managed equity funds. Thus, the risks are lower. The returns from index funds are good during a market rally. But, in times of a market slump, you should switch your investments to actively managed equity funds. It is ideal to have a mix of index funds and actively managed funds in your equity portfolio.

Moreover, index funds try to emanate the performance of the index. Their returns are comparable to that of the index. But, the aspect that demands your attention is Tracking Error. You must pick one with the lowest tracking error.

3. Tax

Since index funds are equity funds, they are subject to capital gains tax and dividend distribution tax.

  • Capital gains tax

When you redeem index funds, you earn capital gains. You need to pay taxes on this income. The tax rate is estimated on the holding period, the duration for which you invested in the fund.

The capital gains you earn on funds with a holding period of up to one year are known as Short Term Capital Gains (STCG). It is taxable at 15%. The capital gains you earn on funds with a holding period of more than one year are known as Long Term Capital Gains (LTCG). You do not have to pay taxes on LTCG of up to Rs. 1 lakh. Any gains above this amount are taxable at 10% without indexation benefits.

  • Dividend distribution tax (DDT)

Before paying dividends, a fund house deducts 10% DDT at the source.

4. Investment horizon

Index funds are suitable for everyone looking to save for the sunset years or other long-term goals. The fund undergoes significant fluctuations during the short run. Holding the fund in the long run, for around seven years, helps to average out fluctuations and offer returns of 10% to 12%. Investors picking index funds should be patient to stick around for at least that long if they want the fund to perform at its full potential.

5. Financial goals

Index funds are suitable for fulfilling long-term financial goals, such as wealth creation or retirement planning. Since they are a high-risk-high return avenue, the funds can generate adequate wealth, enabling you to retire early and pursue your passion in life.

Final thoughts

Investing in index funds and ETFs is a low-cost strategy for an investor’s portfolio. But you must understand what you are investing in before investing in index funds. All index products aren’t the same, and investors must see beyond the “index fund” label to ensure their investment in a low-cost product. The index product must track a benchmark that suits your investing strategy. 

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