With a net worth of more than $107 billion, Warren Buffet is one of the most successful investors of all time. Thousands of investors from around the globe tune into the annual general meetings of Berkshire Hathaway Inc. every year in hopes of getting in on some of Buffet's investing wisdom.
And the one investment advice that the Oracle of Omaha swears by for beginners is index funds. Index funds have emerged as one of the most accepted investment choices due to their low costs and steady returns. These are passive investments that invest in the stock of the index they are tracking.
Apart from being a prudent choice for portfolio diversification, investing in index funds is also the perfect way to lower your equity risk while maximising the returns. Whether you're a beginner or an experienced investor, index funds can be a profitable addition to your portfolio.
Here's everything you need to know about index funds and how to invest in them.
What are index funds?
Index funds are a type of mutual fund that imitate the portfolio of an index. These are passively managed funds and their aim is to track and mimic the performance of stock market indices ike NSE Nifty 50 or BSE Sensex.
A stock market index is an indicator of the performance of the securities market and includes stocks of diverse industries. So, the asset allocation of index funds will be the same as that of the underlying index. This means an index fund offers you the opportunity to invest in diverse sectors with a single fund earning comparable returns.
How do index funds work?
Under passive fund management, the traded securities depend on the underlying benchmark. So, unlike actively managed mutual funds, which are focused on beating the market, index funds are passively managed to match the performance of their index.
Consider an index fund that is tracking the BSE Sensex index. This fund will have the 30 (typically blue-chip) stocks in its portfolio that comprise Sensex in the same proportions. Simply put, the index fund will invest in all the securities (including equity and equity-related instruments and bonds) that the Sensex tracks. The fund manager will decide which stocks will be bought and sold based on the composition of the underlying benchmark.
Why should you invest in index funds?
1. No bias investing
When it comes to equity mutual funds, the fund manager uses his discretion and past experiences to pick an investment strategy for the fund.
However, since index funds are passively managed and mimic the performance of the underlying index, they overcome this human bias. The fund managers don’t have to rely on their judgement to make investment decisions. The fund only tracks the benchmark index and possibility of human error is eliminated.
2. Lower expense ratio
The expense ratio is the percentage of the money you are paying to the AMC for running and managing your mutual fund investments. Since index funds are passively managed, they feature a relatively lower expense ratio. Their asset allocation remains almost the same for the entire period because any change in its composition will only happen when there is a change in the asset allocation of the underlying asset.
3. Broad market exposure
Investing in index funds helps ensure your portfolio is exposed to a range of high-performing assets and industries for maximum diversification. It spreads your investment across a wider market segment and market-cap categories, which effectively distributes the risk and brings good returns in the long term.
How to invest in index funds in India?
You can easily invest in index funds through a hassle-free process as you don't need a Demat account for the same. You can apply online via a secure platform like Tata Capital Wealth or apply directly by visiting the nearest AMC branch of the preferred fund. The offline process will involve the submission of necessary documents along with the payment to get started with the investment.
Here is the step-by-step process to invest in index funds online-
1. Sign up for a mutual fund account via a reliable platform like Tata Capital Moneyfy.
2. Complete the KYC formalities if not done yet.
3. Fill in the necessary information.
4. Based on your financial needs and investment objectives, compare various index funds.
5. Pick suitable index funds and buy units with a single lump-sum payment.
6. You can also opt for an SIP plan with standing instructions for your bank.
Benefits of investing in index funds
Some of the benefits of investing in index funds in India are-
1. Tax benefits
Index funds are passively managed, meaning they don't buy and sell securities as regularly as active funds do. As a result, index funds can reduce your tax liability and increase your after-tax returns.
2. Lower expense ratio
Since they are passively managed, they carry a lower expense ratio and fees than actively managed funds.
3. Manageable
Index funds don't change their asset allocation easily, which makes them easier to manage than actively managed funds. This means the asset allocation remains the same until you change it yourself or a new fund manager takes over.
4. Impartial investing
Index funds eliminate any human discretionary bias in investment decisions using an automated, law-based investment process. In fact, even the amount to be invested in index funds of different securities is mentioned in the fund manager's mandate.
Things investors should consider before investing in index funds
When investing in index funds, you must consider several factors to ensure they align with your financial goals and risk tolerance.
1. Expense ratio
The expense ratio represents the annual fee charged by the fund manager for managing the index fund. Although index funds typically have lower expense ratios than actively managed funds, but even a small percentage difference can significantly affect your returns over time. Always compare the expense ratios of different index funds before investing.
2. Risk and returns
While index funds are considered less risky than actively managed funds, they are not immune to market fluctuations. The performance of an index fund is tied to the underlying index it tracks, meaning your returns will mirror those of the index. Investors should assess their risk tolerance and ensure that the potential returns align with their expectations.
3. Investment goals
Your investment goals should dictate the choice of index funds. Typically, index funds are ideal for investors with an investment horizon of more than 7 years.
Whether aiming for long-term growth, income generation, or a balanced approach, you can easily align your investment goals with these investments.
4. Tax implications
Since index funds are equity funds, they can generate returns through dividends and capital gains, both subject to taxes.
The Dividend Distribution Tax (DDT) is deducted at source at 10% when the fund house makes the dividend payment. Further, redeeming index fund units attract short-term and long-term capital gains tax depending on the holding period.
For example, long-term capital gains from equity-oriented index funds are taxed at 12.5% if they exceed Rs. 1.25 lakh, while short-term gains are taxed at 12.5%. It's important to consider these factors to avoid unexpected tax liabilities.
Wrapping up
Index fund investments are an excellent way to get exposure to a diversified portfolio while minimising your risk and boosting your returns in the long run. If you're ready to take your first step towards index fund investments, look no further than Tata Capital Wealth.
Our financial experts will assist you in comparing, identifying, and investing in the best mutual fund schemes to grow your wealth seamlessly. Visit our website today or download our investment app to know more.
FAQs
1. Is it a good time to invest in index funds?
Index funds are a good investment for long-term goals. They offer diversification and lower costs, making them a solid option regardless of market conditions.
2. Is it possible to lose money in an index fund?
Since index funds track the market, they are subject to market fluctuations. Short-term losses are possible, but over the long term, they tend to recover.
3. Can index funds be considered a good investment?
Index funds are generally considered a good investment due to their low costs and expense ratio, diversification, and potential for steady returns in the long term.
4. How to invest smartly in index funds?
To invest smartly in index funds, choose funds with low expense ratios, align them with your investment goals, and consider tax implications. Regularly review your portfolio to ensure it meets your financial objectives.
