A beginner's guide to index funds: A passive approach to market-linked growth

Index funds can be a suitable avenue for modern investors seeking relatively simple and low-cost ways to potentially build wealth over time. Index funds track market indices like the Nifty 50. They replicate the benchmark index’s portfolio and seek to match its performance (subject to tracking error).

Thus, index funds offer investors an avenue to potentially grow with the broader market.

• Table of contents

• How do index funds work?
• Key benefits of index fund investing
• How market trends impact index fund returns
• Index funds vs. actively managed funds
• Common index fund myths
• Taxation of index funds
• Global vs. domestic index funds

How do index funds work?

An index fund aims to match the performance of a market index like the Nifty 50 or the BSE Sensex. It holds the same stocks as the index it tracks, in approximately the same proportions. For example, a Nifty 50 index fund would invest in the 50 large companies that make up that index.

As the index rises or falls, the index fund follows its performance. However, there can be a difference between the index’s performance and that of the benchmark, which is known as the tracking error.

You can invest in numerous companies at once through a single index fund, diversifying your portfolio.

Also, index funds are passively managed. The fund manager makes few trades, to keep costs low and closely mirror the index. In contrast, actively managed funds have managers picking stocks and trading frequently, attempting to beat the market in the long term.

Key benefits of index fund investing

Here are some key advantages of index funds that have resulted in their popularity:

Low costs

Index funds don't require extensive management because they simply track the market. This keeps fund expense ratios low.

Diversification

Investing in an index fund provides diversification across many stocks and sectors (for broad market indices). This mitigates portfolio risk compared to owning just a few stocks.

Market-linked returns

Index funds seek to match the market, not outperform it. As the economy grows, markets also tends to perform well, and index funds give investors the chance to tap into this growth potential.

Simplicity and convenience

Index funds require little maintenance once purchased. The fund manager handles trading, rebalancing, and administering the fund. It's a simple, low-effort way to invest in many stocks.

How market trends impact index fund returns

Index funds directly correspond to market performance. Their returns are determined by broader economic and market trends.

For example, during recessions, stock markets typically decline as uncertainty rises. Index funds would fall in value too. However, markets have historically* rewarded investors over long periods despite short-term volatility.

*Past performance may or may not be sustained in the future.

Specific market events can also directly affect index funds.

• Interest rate changes can impact debt indices or equity indices comprising of many rate-sensitive stocks like utilities and real estate.
• Global oil price shocks may cause energy sector stocks to underperform, lowering returns for broad market indices weighted towards this sector.
• Strong earnings results from major index components can lift index fund returns.

Index funds vs. actively managed funds

In actively managed mutual funds, fund managers handpick stocks and adjust portfolios based on their investment objectives and outlook (subject to regulatory guidelines). Actively managed funds seek to create a portfolio that is distinct from the benchmark, seeking to outperform the market in the long term. However, this results in them having higher expense ratios. For some fund categories, risks may also be higher, as stock selection plays an important role in impacting returns.

Index funds offer simplicity, diversification and low costs. But if you have time and interest to research, some active funds may complement an index fund portfolio. Many investors use a mix of passive and active funds.

Common index fund myths

Despite their benefits, index funds also have some misconceptions attached to them. Here are common index fund myths and the realities.

Myth: Index funds always carry lower risk than active funds.

Reality: All funds carry market risk based on their holdings. Some active funds invest in lower-volatility stocks than benchmark indices like the Nifty 50. They may pose less risk.

Myth: Index funds lack diversification.

Reality: Broad index funds hold hundreds of stocks across sectors, providing instant diversification. However, index funds that track specific sectors may have a narrower focus.

Myth: Index funds require less research than active funds.

Reality: You still must research factors like costs, holdings, and index tracked when selecting index funds.

Taxation of index funds

Capital gains on index funds are taxable. The tax rate depends upon the portfolio composition. Equity-oriented index funds are taxed as follows:

1. Short-term capital gains tax: Levied on units held for less than a year. The tax rate is 20%
2. Long-term capital gains tax: Levied on units held for more than a year. Gains of up to Rs. 1.25 lakh are tax-exempt. Thereon, the tax rate is 12.5%.

For debt index funds, all capital gains are deemed to be short-term capital gains and taxed as per the investor’s applicable income tax slab rate.

Global vs. domestic index funds

Index funds can track domestic indices like the Sensex, foreign indices like the Nifty 50, or global indices covering stocks worldwide.

Here are factors to weigh when choosing global vs. domestic index funds:

• Diversification - Global index funds provide exposure to more markets and sectors worldwide. This reduces portfolio risk.
• Market growth rates - Developing markets with growing middle classes like India may offer higher growth potential than mature economies.
• Currency fluctuations - Global funds carry currency risk as foreign stock gains can be offset by a weakening rupee.
• Familiarity - Indian investors may feel more comfortable investing heavily in domestic companies they know and understand.

Many investors use a mix of domestic and global index funds to balance higher growth opportunities in Indian stocks with the diversification of foreign index funds.

Conclusion

Index funds offer a straightforward way to potentially build long-term wealth through the stock market and capture market gains over time. With their simplicity, diversification, low costs and tax efficiency, index funds can be a suitable addition to a portfolio.
Consulting with a financial advisor and doing adequate research can help you make well-informed investment decisions.

Frequently asked questions:

Why are index funds considered a suitable investment choice?

Index funds provide a simple, low-cost way to invest in the stock market. Markets tend to rise over decades. Owning index funds allows investors to capture these long-term gains through steady, disciplined investing over long time periods.

How do index funds reduce risk compared to actively managed funds?

The risk level depends upon the portfolio composition. So, an equity index fund will be riskier than an actively managed debt mutual fund. However, between two funds with a similar investment universe, an index fund can be less risky because an actively managed fund’s performance depends significantly on the fund manager’s strategy and stock selection, whereas an index fund does not carry this decision-making risk.

Can index funds provide consistent long-term growth?

Returns are not guaranteed in any mutual fund investment. However, while markets fluctuate in the short term, they have historically grown over longer periods.

*Past performance may or may not be sustained in the future.

While markets fluctuate, they have rewarded investors over long periods. By closely tracking market indices, index funds allow investors to participate in long-term market growth through recurring investments over years and decades.

Are index funds suitable for first-time investors?

Yes, index funds can be a suitable starting point for beginner investors. They provide a low-maintenance way to gain exposure to many stocks through a single fund. Depending upon the asset management company, investments can start from Rs. 500 or Rs. 1,000 generally, enabling affordable investing.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.