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Why Index Funds are Good Investments?

IndianMoney.com Research Team | Posted On Tuesday, November 05,2019, 12:13 PM

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Why Index Funds are Good Investments?

 

 

An index fund is a mutual fund which imitates the portfolio of an index like the Sensex and Nifty. These funds are called index funds or index-tracked mutual funds because they track an index. In theory you get a performance identical to that of the index being tracked.

Index Which Tracks Nifty: If the index tracks the benchmark like Nifty, the portfolio has 50 stocks that comprise the Index and in the same proportions. Index funds are passively managed funds. Buying and Selling happens in-line with the composition of the underlying benchmark.

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Why Index Funds are Good Investments?

Index Funds for Those with Low Risk Appetite:

There are several people who don’t like their investments in mutual funds to be managed actively, by a mutual fund manager. They would love their funds to be passively managed. These investors mostly those with low risk appetite prefer index funds.

Index Funds track a particular index and are passively managed. The fund manager decides the stocks to be bought/sold in line with the composition of the underlying benchmark. (Sensex or Nifty). There isn’t a standalone team of research analysts to select stocks and identify investment opportunities.

Index Funds are low cost funds. You can save anywhere between 0.5% to 1.5% each year through an index fund vs actively-managed funds. These savings can be significant over the long term.

Investing in stocks is a high risk- high return game. You could make high profits or suffer heavy losses. Index Funds are not affected by the rise and fall of a single stock or even a sector. You also don’t have the hassles of maintaining a demat account.

See Also: All about Mutual Funds in India

Why are Index Funds Cheap?

Index Funds replicate the indices like Nifty and Sensex. As there is no active fund management (This constitutes a passive investment), lower costs are passed on to the investor in the form of a lower expense ratio. (Expense ratio is the total cost of the fund).

The index funds follow the set it-forget it strategy. Returns never stray too far from the market.            

Index Funds are Better Than Actively Managed Funds:

Active fund managers who beat indices have shown no great consistency in doing so. They are merely lottery winners. Index Funds tend to perform better than actively managed funds over the long term. They are ideal for retirement planning. Index Funds are low cost funds. This translates to a huge savings over the long term.

  • Index Funds are great for risk-averse investors.
  • You can invest in equity at low cost.
  • They track a broadbased index with small tracking error.

See Also: Mutual Fund Returns

Why Invest in Index Funds?

  • If you can’t bear volatility in the equity markets, go for index funds. They are less volatile vis-a-vis large-cap funds.
  • There are index funds which have low expense ratio of 0.1-0.3%. They also offer good returns.
  • The index fund which tracks the Nifty-50 is a well-diversified portfolio of 50 Companies.

See Also: How To Invest In A Mutual Fund For Beginners?

Points to Note Before Investing in Index Funds

  1. Index Funds lose their value when stock markets are crashing. (Stock Market Slump). It would be wise to have a mix of actively and passively managed funds in your portfolio.
  2. Index Funds do not try to beat the index, only replicate it. There would be a slight difference in returns vis-a-vis the index, because of tracking error. This would result in deviation from actual returns.
  3. Index Funds could have 0.3-0.5% expense ratio. This is less vis-a-vis actively managed funds which have 1-2.5% of expense ratio. This is because no fund manager is required to formulate an investment strategy.
  4. The capital gains (profits) from index funds are taxable. The taxation rate depends on the holding period. (This is how long you have invested in the index fund). The gains you make up to a year are called short-term capital gains. These are taxed at 15%. The capital gains earned after staying invested for more than a year are called long-term capital gains. LTCG over Rs 1 Lakh are taxed at 10% without indexation benefit. Indexation benefit allows the inflation of purchase price using the cost inflation index.

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