Introduction to Index funds

What are Index funds? 

Index funds are types of mutual funds, which mirror the portfolio of the index. As these funds map the performance of the underlying benchmark, the returns of these index funds are the same as the index. These funds are passively managed as fund managers do not play an active role in selecting the security & articulating the strategy. Fund managers match the investment with the underlying index. For example: If the underlying index is Nifty 50, then the portfolio of the index fund will consist of 50 stocks, replicating the same stocks in the same proportions.  

Investors must consider the following pointers before investment-  

Risk capacity: As these funds are a reflection of the underlying index, investors, who are ready to take risks should invest in these funds as there is the market as well as volatility risk.   

Cost: Index funds usually have low expense ratio as compared to actively managed funds, which leads to generating more returns. Index funds generate similar returns as benchmark indices; sometimes, there can be some difference, which is known as ‘tracking error’. Then the question arises - Which index fund should you choose to invest in? Ideally, you should choose an index fund, whose expense ratio as well as tracking error is lower.   

Investment horizon: Ideally, investors, who are ready to invest for longer-term should choose to invest in these funds as they offer sounder returns if invested for a longer-term (i.e. at least for 7 years) than short-term investors as in short-term, fluctuations are experienced.  

Taxation: You earn capital gains on the redemption of units of the index funds. If you were invested for the shorter-term i.e. up to 1 year, then the tax rate will be 15 per cent on short-term capital gains (STCG). If you were invested for longer-term i.e. for more than 1 year, then gains up to 1 lakh will be exempted and any gains above 1 lakh will be taxed at 10 per cent on long-term capital gains (LTCG).