Working 9 to 5 jobs and living paycheck to paycheck is a thing of the past. In such a competitive market and the increasing cost of living, one source of income is the least to survive. Creating a passive source of income is a must to live life on your terms, but that is easier said than done.
Investing in the stock market is an excellent way for you to make a good return on your money. But this high return comes at a risk. Not everyone has a knack to pick stocks like warren buffet and create a sizable portfolio.
Index Fund is an an alternative that can make you reasonable returns with minimal effort.
You can invest your money in an index fund, sit back, and watch your investment multiply. Qualified fund managers manage an index fund. The funds are cost-efficient and diversify your investments across various stocks/bonds.
I will explain what index funds are, how they work, and why they are the right investment for you
Index/Benchmark
To be able to understand the working of an index fund, I will first give you a crash course on what an INDEX is.
An index is a basket of securities that consist of the best-performing stocks in a category. You can think of an index fund like a Cadbury celebration box. The box (Index) contains the best chocolates (securities) for you to enjoy (Invest).
An index can comprise of -
1. Market Capitalization of companies - The most valuable companies in the market
2. A company's earnings - High-income growth or lower price-earnings ratio
3. A sector of the economy - IT, Banking, Metal, etc.
The Indian stock the market has 2 broad market Indices - SENSEX and NIFTY.
The SENSEX is the Bombay Stock Exchange (BSE) index which includes the top 30 companies listed on BSE
The NIFTY is the market index of the National Stock Exchange (NSE). It includes the top 50 companies listed on NSE.
BSE has more than 5000 companies listed and NSE has more than 1600 companies listed. This makes it impossible to keep track of every stock’s performance
The indices are a proxy for the performance of the broader financial market of a country. They act as a benchmark for performance appraisal of portfolios.
A portfolio that beats index returns is an "Outperformer". This implies that the investor has earned a higher return than the index.
A portfolio with subpar returns to the index is an "Underperformer”. This implies that the investor has earned a lower return than the index.
Index Funds
Index funds are a type of mutual fund that mimics the performance of an underlying index. John Bogle introduced these funds in the year 1975.
Indexes are a great way to invest in the broad market growth of an economy, but investors cannot invest in an index.
Even if you were to build a portfolio by exactly replicating the index, it would be expensive and foolish.
Index funds are a cost-effective alternative for investors to have a diversified portfolio. They recreate the index they track by buying all the underlying securities of the index.
The trading fees for such funds are generally low as constituents of an index seldom change.
Index funds are a great way to build your wealth. They offer a diversified holding of securities, low costs, and market returns.
Categories of Index Funds
Various indices represent different segments of the financial market. These indices have index funds tracking and replicating the performance of the index. This allows you to invest in an index that suits your risk appetite. Some of the categories of Index funds are –
1. Broad Market –
If you are looking for broad exposure to the market, broad market index funds are your best bet. They seek to capture a wide range of the market by investing in a large segment of the market. Investments made are either in equity or debt instruments. The low asset turnover of these funds makes them tax efficient.
E.g. – DSP Blackrock equal NIFTY 50 Fund, HDFC index fund – NIFTY plan, Birla sun life index fund
2. International –
Most of you want to invest globally. Be it in the top international companies or emerging/developed markets. You can diversify your investments beyond your markets through international index funds. These funds mirror international market indices like the S&P 500, NASDAQ, etc.
E.g. – ICICI Prudential US Bluechip equity fund, Nippon India US Equity Opportunities Fund, DSP Blackrock US Flexible Equity Fund.
3. Market Capitalization –
Most broad market index funds are overweight on large-cap companies. This leaves you with little - to - no exposure to small and mid-cap companies. Market cap index funds solve this issue by including small and mid-cap indices. Small-cap companies tend to outperform the market in the long run but are volatile and risky. Exposure to such index funds gives your portfolio a balanced risk-reward ratio.
E.g. – Motilal Oswal Nifty SmallCap 250 Index Fund
4. Debt –
Debt index funds are perfect for those, who want stable returns with low risk. Long term debt funds offer high yield at a higher risk as they are prone to the effects of changes in interest rate.
Short term debt funds offer a low risk – low yield ratio. They are not prone to interest rate fluctuations due to their shorter tenure. Intermediate debt funds fall somewhere in the middle.
A balance of Long term, intermediate and short - term debt funds is an ideal allocation. It helps in reducing interest rate volatility and generate steady revenues.
E.g. – Bharat Bond ETF.
5. Earnings Based –
Earnings based index funds invest based on the earnings/profits of a company. Classifications of earnings can be -
a. Growth – Earnings of Growth companies tend to grow faster than their peers.
b. Value – Value companies are those companies, that trade at a lower multiple of earnings.
You can choose your index funds according to your investment philosophy.
6. Dividend focused –
Dividend focused index funds focus on companies that have a high dividend yield. The dividend payout to the unitholders is at regular intervals. For those of you who are looking for a regular cash inflow and do not mind the equity risk, this fund will suit your needs.
E.g. – ICICI Prudential Dividend Yield Equity Fund, UTI Dividend Yield Fund, Aditya Birla Sun Life Dividend Yield Plus Fund.
7. Sector –
Each market cycle has sectors that outperform the market. But some of us struggle to make the right stock picks in that sector. This results in an underperforming portfolio even when the sector has had a strong run. Sectoral index funds allow you to invest in the sector of your choice. This removes the time-consuming process of stock picking across sectors.
E.g. – ICICI Prudential Technology Fund, Invesco India Infrastructure Fund, SBI Banking & Financial Services Fund.
8. ESG Funds –
ESG funds are tailor-made for those of us who wish to invest in a better tomorrow. ESG stands for – Environment, Social, and Governance. ESG funds invest in companies that are -
Environmentally conscious, Socially Responsible, and Ethical in its governance.
E.g. – SBI Magnum Equity ESG Fund, Quantum India ESG Equity Fund, Axis ESG Fund.
9. Leveraged Index Funds –
Leveraged index funds use debt to amplify their returns. This looks like an attractive option, but using leverage is a double-edged sword. The losses are also amplified when things go south. These funds are not suitable for everyone. Invest only if you have a high-risk appetite and a long investment horizon.
10. Inverse Index Funds –
An inverse index fund IS also known as “Short ETF” or “bear ETF”. The ETF uses derivatives and options to profit from a decline in the value of an index. The frequent trading of derivative contracts increases the expenses of the fund. These expenses pass on to investors in the form of a higher expense ratio.
These ETFs are risky instruments that you should approach with caution. Experienced traders and investors use them to hedge their portfolios. They are also invested in to profit from market declines. On a long time horizon, market indices have shown an uptrend. Hence, inverse ETFs should not be a part of a buy – and – hold investors’ portfolio.
Advantages of investing in index funds
1. Cost-Efficient –
The low expense ratio and transaction fees make index funds cost-efficient. Investors tend to undermine the effect such costs can have on their funds’ returns in the long run. A low-cost fund means that you get to keep most of the gains of your portfolio.
2. Hassle-free –
Index funds save you the trouble of finding excellent businesses at fair prices. The funds invest in the top companies in their respective categories.
3. Diversified –
The index funds invest in a variety of stocks or bonds. This gives you the benefit of diversification and balances your risk
4. Low risk –
This is one of the major benefits of an index fund. The low performing securities get replaced with better performing security. This saves you from the despair of seeing your portfolio go down to nil.
5. Steady Growth -
The performance of businesses has increased over time and so have their valuations. This implies that markets have been growing for the past many decades and will do so in the future. Index funds provide you an opportunity to invest and reap profit from this growth
Disadvantages of investing in index funds –
1. Average Returns –
Index Funds aim to reproduce market returns, and not beat them. This limits your gains to market returns.
2. Lack of downside protection –
Actively managed funds sell stocks during a crash to protect their returns. Index funds do not indulge in any such selling. During a market crash, your portfolio can generate negative returns.
3. Lack of flexibility –
The funds invest only in the securities comprising the index. This leaves you with no flexibility over the securities in the funds' portfolio.
Who should invest in index funds?
Index funds should be a part of the portfolio of the following categories of investors. Although I recommend everyone to have an index fund in their portfolio –
1. First-time Investors – Index funds will give new investors an idea of market operations. You will be better informed about the stocks and the broader market. This will enable you to make well-informed investment decisions. It will also help you in building up your confidence.
2. Passive investors – Passive investors don’t wish to indulge in stock picking. They are content with market returns, as long as they don't have to make any extra efforts. Index funds check these boxes. They do not need any extra time and effort from your side and make you reasonable returns.
3. Risk-Averse Investors – Risk-averse investors usually prefer fixed income instruments, like Fixed Deposits. They prefer low returns as long as their investment is safe. Debt index funds are a better alternative. They offer better returns than your FDs and have liquidity, that is, they are redeemable at any moment.
4. Early - Retirees - Nobody wishes to work till the time their 60. But not everyone has the leisure to retire early. Started early, your index fund portfolio will allow you to retire early. You can live a comfortable life off your investments.
How to Invest in Index Funds?
The easiest way to invest in index funds is through the following means –
1. A broker – A broker can help you select the right index funds and carry out the whole process for you. The broker should be a member of the Association of Mutual Funds of India (AMFI). They charge extra fees for their services, which can hurt the gains of your portfolio.
2. Through the AMC website - For direct investment, you can visit the mutual fund AMC website. Scroll through the funds managed by the AMC and invest in the fund of your choice.
3. Fintech apps - Fintech apps like – Groww, Zerodha Coin, etc. have made investment easier than ever. You can invest in index funds from their platforms in a matter of minutes.
Choosing the right index fund
Picking an index fund for investment is far easier than picking individual stocks. The following points will help you make the right pick -
1. Goal – Before you start investing, it is important to have a goal in mind that you wish to achieve. Your goal can be any of the below and your choice of a fund should complement that -
a. Long Term Growth – Equities have given better returns than other asset classes. The high returns are volatile and are not suited for everyone. Equity index funds are for those who have a long-term investment horizon.
b. Stability – Not everyone wishes for high returns. Some of us want an investment that generates stable revenue. Debt index funds will be best suited for you.
c. International Exposure – Exposure to global markets gives your portfolio an edge. Foreign markets may offer better valuations and growth prospects. They also aid in hedging your portfolio against local events.
2. The Underlying Index – Various stock market indexes represent a wide variety of companies. You need to know the index you want to invest in – Growth, Value, Sectoral, or market cap. Choose the index that best fits your investment style.
3. Expense Ratio – The expense ratio is the part of assets that a fund uses to run its daily operations. A high expense ratio can hamper your portfolio gains in the long run. Your choice of a fund should be the one with the lowest expense ratio.
4. Tracking Error – It is the difference between the returns of the fund and the underlying index. You should abstain from investing in a fund with a high tracking error. The returns of such a fund tend to underperform the index. Go for funds with the least tracking error. They will deliver returns nearest to the benchmark.
5. Fund manager – The fund manager handles your investment. It is prudent to consider his/her qualifications and past performance before investing. After all, they will the one responsible for your portfolios' performance
Some of the top-performing Index Funds –
|
Scheme Name |
AuM (Cr) |
1Y Returns |
3Y Returns |
5Y Returns |
|
HDFC Index Fund |
1,348.99 |
1% |
6% |
8% |
|
UTI Nifty Index Fund |
2,362.15 |
-1% |
5% |
7% |
|
SBI Nifty Index Fund |
906.80 |
-1% |
4% |
7% |
|
Nippon India Index Fund |
84.59 |
1% |
6% |
7% |
|
Nippon India Index Fund |
212.01 |
-1% |
4% |
7% |
|
IDFC Nifty Fund |
208.08 |
0% |
5% |
7% |
The above returns are for investment via Direct Plan. Returns for Regular plan will differ.
Source - https://www.moneycontrol.com/mutual-funds/performance-tracker/returns/index-fundsetfs.html
Taxation of Index Funds – Gains from the sale of units of index funds are taxable as capital gains. Capital gain is the difference in the value of the sale price and the buying price of the units. If sale price > buying price, it would be taxable as capital gains. But, if the buying price > sale price, it would amount to capital loss. Capital losses are not taxable but assist in setting-off your capital gains. This reduces your taxable income and the amount of taxes paid.
Index funds taxation is dependent on Investment type and investment duration. Investment type is either into Equity or Non-Equity Oriented schemes. The investment duration is either into Long-Term or Short-Term
Picture Credits – Paisabazaar.com
*Long Term Capital gains on equity funds are exempt up to Rs. 1 Lakh. For Example, if your long-term capital gains from equity funds are Rs. 1.25 Lakh, only Rs 25,000 is taxable.
You know everything to make a smart investment decision. All you need is to take action that will put you in control of your finances and your future. For those of you who are already investing – You are already ahead in the race. Keep up the good work. And for those who are yet to take an action – It's still not late.
An investment today can go a long way to ensuring you lead a comfortable life.
Disclaimer – The above post is for educational purposes. Investors are requested to do their due diligence before making an investment decision.
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