What are Index Funds?
Created on 23 Feb 2021
Wraps up in 5 Min
Read by 2.2k people
Updated on 27 Jul 2022
Markets nowadays are rallying too much, aren't they? There is not only heavy volatility due to the pandemic and the circus surrounding the vaccine, but there is also fear amidst the investors. So every investor seems to be set on a voyage to locate the best possible way to keep their capital safe and increase their returns.
In times like these, having a diversified portfolio can be useful. When analyzing the various low-risk investment alternatives, there is one thing that easily slips through our mind. The index funds.
Index funds are those which invest your money into the index stocks in the same proportion.
They are like those backup options which can save you when your frontline plans fail. It not only offers diversification but also gives attractive returns when invested for more than 5 years.
Let quickly have a tour to understand what an index fund is and what are the various benefits associated with it.
Understanding Index funds
Index funds are the type of funds that imitates the portfolio of an index like, NIFTY stocks which consist of the top 50 shares of the market or the SENSEX stocks, which include the top 30 shares of the market. These stocks act as representatives of the entire market (Sensex or Nifty) and give an overall view as to how the entire market is functioning.
In addition to that, Index funds, unlike other mutual funds, are passively managed. That is, the fund manager simply invests the money in the respective stocks and leaves it. They do not constantly monitor, switch or try to increase returns.
So at the end of the day, your returns rely on how the market or the index stocks perform rather than being dependent on the fund manager's abilities.
Since the index funds are passively managed, they have a low expense ratio when compared to the other actively managed equity funds in the market. In the case of an Index fund, your expense ratio will stand at 0.5% or lesser.
Index funds attract both short term capital gain tax (STCG) and long term capital gain tax (LTCG). Any withdrawal of returns in the short term is taxed at 15%, and in the long term, which is more than a year, you will be required to pay a 10% tax for any amount over and above 1 lakh.
Things to Consider While Investing in Index Funds
While opting for index stock, there are certain things that should always be considered:
Index funds are recommended for those who hold a highly risk-averse profile. As investments are focused upon investing into index-based funds, the risk associated with them lies on the lower side. Further, investing a small portion to fulfil your aim of diversifying your portfolio will bring no harm.
In short, the proportion of capital that goes into your index funds must be based on the risk you are exposed to.
Index funds belong to the long term fund category. And hence, if you are looking for investment for, say 2-3 months, then it will be a good option to look at other short term funds available in the market.
Because index funds usually require a time between 5 -7 years to reach their fullest potential and generate returns of about 10-12%. So, staying with the funds for such a long period is essential and hence, the duration till which you are going to stay invested also matters a lot.
Let's assume that the market is seeing a huge fall, and you are looking to invest. In that case, index funds may not be a viable option. Several other investment options might help you save your portfolio while generating a satisfying return.
Hence, market conditions should always be considered before deciding to invest in index funds.
Your goals and objectives
When you start the mission of investing, the end line should always be the accomplishment of your financial goals and objectives. Hence, all your investments must be planned accordingly.
Blindly taking up any investment, even be it index funds, might help you in seeing some good returns, but it may not be enough to get your goals fulfilled. So, it is important to ensure that the advantages associated with index funds are not deviating you from your ultimate financial objectives.
Tracking error is the difference between the actual performance of the index and the actual performance of the funds. As mentioned earlier, the index funds must adapt to the same path as the market index. Any differences in the same will be termed as tracking error.
Ensure that your chosen fund has a small difference between the two. Checking the past tracking error of the various index funds in the market might help you choose the right one.
Should you Invest in Index Funds?
Now let's find the answer to the most crucial question that might be running in your mind. Should you opt for index funds?
If you are someone who is associated with an actively managed portfolio, then index funds can be a perfect lifeguard. It will diversify the risk and help you get something even when everything goes against your will, provided that you are ready to stay invested for a longer period.
Index Funds can also be ideal for those who are holding a risk-averse profile.
The Bottom Line
So everything drives down to one single point, and that is what you actually want from your investment.
This is something that will drive all the other important decisions, such as the time horizon, risk averseness, etc. so that you can reap the maximum benefits out of your investment.
So decide, choose and then invest. However, holding a diversified portfolio is a must, and an index fund can help you with that.
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