What are Index Funds: meaning, advantages, review, Taxation

(Last Updated On: June 24, 2017)

Index funds are mutual funds in which investment are made in the stocks of Index they track such as Nifty, Sensex according to its composition and weightage of the index. In this blog, we review about what are index funds, their advantages, disadvantages, taxation benefits and performance.

Index funds are basically the replicas of stock indices they track. These are low-cost investment option and its easy to track its performance by its index. Index Funds are passively managed funds as it does not involve research and stock picking by fund managers.

Features Of Index Funds

Diversification: An index represents the economy of the country and its performance. It includes companies from different sectors having high market capitalisation. As fund follows the index, it allows investors to achieve diversification and broad exposure to large companies. It helps to reduce volatility in the fund.

Low Cost: Index funds are less expensive compared to other equity funds. This is because of the passive style of management. The fund manager in Index funds does not require research for selection of stocks and building portfolio because investment in securities is determined by the index and also there will less adjustment of the portfolio, which will help in reduction of brokerage and transaction cost. This results in a decrease in management fees and other expenses.

Returns: The returns in Index Fund is determined by the performance of index they track. It follows the same line of growth with the index. An index fund cannot beat its benchmark in terms of returns and may vary due to tracking error of the fund.

Liquidity: Index funds are highly liquid in nature because the stocks in the portfolio are of well-known large companies whose stocks are traded with huge volume. So it becomes convenient for investors to buy/sell index funds.

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Advantages and Disadvantages of Index Funds

Advantages

Low risk and steady growth: The main objective of Index funds are steady and long-term growth with low risk. The index funds are well diversified across sectors within an index which helps in reducing the downside risk of the portfolio. It also helps in attaining steady returns from the funds.

Making money in longer run: Many index funds outperform actively managed funds in the longer run. As a market index manifest the true picture of the economy, the same is reflected in index funds. In the longer run, it is always expected that economy will grow which will result in an increase in returns of index funds.

Easy to Track: An investor with less knowledge in mutual funds can also easily track the performance of the fund. It does not require to understand the viewpoint of fund manager and investment strategies.

Less Fees: The biggest advantage is of less expense ratio of the fund. As the role of fund managers are limited, the expense in managing the fund is low, thus the benefit is transferred to investors.

No effect on the change of fund manager: As used to be in the actively managed fund, where a change in fund manager results in deviation of performance of the fund, Index Fund don’t have the risk of deviation of performance in case of fund manager change because there is no change in the strategy of investment.

Disadvantages

Lack of flexibility: An Index Fund is required to match the footstep of its tracking index, there is no flexibility in formulating an investment strategy. It cannot change its holding in the case of a huge decline in the price of a stock. It has to wait till it is pulled out of index composition.

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Buy high/sell low: An Index always track market capitalization of the stock. The increase in the price of a stock changes weightage of the stock in the index and vice versa in case of a decline in price. A fund manager has to adjust the weightage in the fund by buying the stocks at a high price and selling at low prices.

Don’t consider future: An actively managed fund identifies a potential stock at a very early stage when it is trading at a low price and can react when the stock is doing bad but in the case of an index fund, it has to wait till its inclusion or exclusion from the index composition.

Low market cap sectors are not included: An Index is a composition of large market capitalized stocks. Small and Mid-cap stocks are not included in the index.

Hold the stock till they are pulled out of the index: A stock is not pulled out of an index till their market cap has reduced significantly or has serious governance issues. A fund manager also has to hold the stock in its portfolio till the official confirmation is received from the index.

Performance of Nifty and Sensex

Nifty 50 represents top 50 companies from 22 sectors of the economy. The overall weight age of sectors have largely same over the period but companies have changed due to change in market cap. CAGR of Nifty for the last 10 years, 5 years and 1 year is 9.4%, 17.15%, and 21% respectively. 

BSE is the oldest stock exchange in Asia established in 1877. It represents the 30 component stocks representing large, well-established and financially sound companies across key sectors. Sensex was established in 1986 and is also considered as an economic indicator of India to the world. CAGR of Sensex for last 10 years, 5 years, and 1 year is 8.7%, 16%, and 19.4% respectively.

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Taxation of Index Funds

Any fund with more than 65% of asset in equity portfolio is treated as an equity fund. Index funds come under the classification of equity fund as the full portfolio is invested in equity. Investment more than one year in equity fund is treated as a long-term investment and the tax implication is Nil. If an investor sells his/her investment in less than one year it is categorised as a short-term investment and tax implication for short-term capital gains are taxed at 15%. Dividend income is tax-free in the hands of the investor.

Conclusion

The performance of the Index Fund is dependent on macroeconomic environment and composition of the tracking index. In long run, it may outperform the many actively managed equity fund. The fund is not designed to deliver short-term returns. One has to stay invested for longer time period, so as to overcome some of the disadvantages associated with the fund.

Further Suggested Reading:

Best Index Funds to Invest in 2017

List of Index Funds

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