The BuyT Desk
A stock exchange is a place for the trade of securities like shares, bonds, commodities, and derivatives. India’s primary stock exchanges are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Other exchanges like Calcutta Stock Exchange and Metropolitan Stock Exchange also exist. Securities and Exchange Board of India (SEBI) recognizes nine stock exchanges in totality. The exchange reveals indices as an indicator of its performance. Out of thousands of companies listed in the exchange, only the top cream makes it to an index. The benchmark indices of BSE and NSE are S&P BSE Sensex and Nifty 50, respectively.
Now that you have understood stock exchange indices let us talk about Index funds. An Index fund is a mutual fund type wherein the fund manager tracks benchmark indices and prepares the portfolio accordingly. The proportion of stocks of companies in the portfolio is the same as that in an index. An Index fund is also a passive fund because it does not require active management instead of other mutual funds. The returns from an Index fund mimics the performance of the underlying index. Research studies have postulated a theory that no investor can surpass the market in the long term. As the basis of Index funds is the market performance, thus over a period, they will outperform all the actively managed funds.
How is investing in Index funds advantageous?
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Index funds are less volatile; thus, investing in Index funds has limited risk.
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Frequent research for selecting stocks and regular buying and selling of stocks requires money, time, and effort. You can avoid the hassle by directly selecting an index for investment.
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Different indices are available for investment.For example, large-cap, mid-cap, small-cap indices; or sector-wise indices.
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Your expenses, like the fund manager’s fees, are relatively lower in the case of Index funds compared to actively managed mutual funds, such as equity or hybrid mutual funds.
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An index constitutes stocks of top-performing companies from varied sectors. Thus, there is diversification in Index funds automatically. Diversification of investment provides a cushion against market fluctuations.
Who should invest in Index funds?
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Investors who are interested in equity investment, but want to take less risk.
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Investors desirous of returns that are predictable but higher than returns from fixed deposits.
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Investors who have long-term financial goals like retirement.
How are Index funds taxed?
Long-term capital gain (LTCG) tax applies when you sell Index funds after one year of investment. The LTCG tax is 10% without indexation and 20% with the benefit of indexation. However, LTCG up to Rs.1 lakh is exempt from taxation. If you sell Index funds before one year, then a short-term capital gain (STCG) tax of 15% will be applied. In case you opt for dividend payout then a Dividend Distribution Tax (DDT) applies at the source. The effective DDT for Index funds is 11.65 %.
What is the flipside of Index funds?
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So far, in India, well-managed funds have shown greater returns as compared to passive funds.
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Investing in Index funds deprives you of the earnings from stocks of high potential emerging companies.
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There is a possibility of tracking error in Index funds. Tracking error refers to the difference between an Index fund’s returns and the expected returns from the underlying index.
To conclude, before investing in an Index fund, you should have at least a mid-term investment horizon, account for the risk of tracking error and be ready to sacrifice the possibility of higher returns from direct trading of equity securities.
