Index Funds

 

If you fall under any of the following categories and not investing in MUTUAL FUNDS then you are surely missing out on a big opportunity that can set you on the path of financial growth.

1. You have funds lying idle in your savings account and you do not need them for at least 5 years. OR
2. You want to start investing for long term goals like retirement planning, children education etc. OR
3. You have just started earning, unmarried with no liabilities and below 30 years of age.

Likewise, there are many such scenarios where investing in equities is the ideal way through.

 

 

 WHAT ARE MUTUAL FUNDS? 

 “MUTUAL FUNDS” is one of the most efficient and systematic way of investing in stocks of various companies across different sectors with limited funds. They invest more than 65% of their assets in direct equity and hence generates the highest returns across all asset classes including gold, real estate, debt, etc.

A mutual fund company known as an “Asset Management Company” (AMC) forms a common pool of funds from the public and invest them into quality stocks of various companies. Hence, by investing just Rs. 10,000/-, your money gets diversified across 20-25 best companies.

This fund is managed by professionals known as “Fund Managers” who are qualified enough to understand the market dynamics and try to accomplish growth by making strategic investment decisions.

On investing, investors are allotted units where the value of each unit is determined by a concept called “Net Asset Value” (NAV) that is declared on a daily basis to determine your fund value and eventually your gain and loss from the investment.

There are 2 ways of investing in Mutual Funds.

1. Lumpsum Investments – Where the entire chunk of money is invested in one go. For example, a fixed deposit

 

2. Systematic Investment Plan (SIP) – Where you invest a fixed amount every month to benefit from rupee cost averaging. So you can invest part of your salary every month in mutual funds. For example, a recurring deposit.

 

You generally get 3 options while investing.

1. Growth – In this option, your money keeps growing and all the returns it generates are put back into the fund. Hence, you only get money on redemption but your money grows at the much faster pace in this option.

 

2. Dividend Payout – In this option, all the dividends are paid out to the investor as and when declared.

 

3. Dividend Reinvestment – In this option, all the dividends are reinvested into the fund and are used to buy additional units instead of paying out to the investor.

 

 

TYPES OF MUTUAL FUNDS

1. Open-ended – Units under open-ended funds are open for purchase or redemption throughout the year. These funds are open for investment or redemptions at all times without any restrictions.

 

2. Close-ended – These are the funds in which buying and selling of units are only possible during the pre-defined period. Under close-ended funds, units can be purchased only during the ”New Fund Offer” period. Likewise, units can be redeemed on “Maturity” only. To provide for liquidity, these schemes are often listed for trade on a stock exchange.

Unlike open-ended , once the units or stocks are bought, they cannot be sold back to the AMC, instead, they need to be sold at the stock market at the prevailing price of the shares.

 

3. Interval funds – These funds are a combination of open-ended and close-ended funds. The asset management company offers to repurchase units from existing unitholders at different intervals during the fund tenure. If unitholders wish to, they can offload shares in favor of the fund.

 

Mutual Fund houses also provide 2 plans to invest in their schemes –

1. Direct Plans – By opting for this plan while investing in mutual funds, you eliminate the services of a mutual fund distributor/agent / financial planner and invest directly with the fund houses.

The transaction can be performed online or even physically by visiting the registrar’s or the asset management company’s office. The expense ratio of direct plans are marginally lower as it eliminates the commission of distributors.

 

2. Regular Plan - This is a conventional way of investing wherein you do transactions through mutual fund distributor/agent / financial planner.

Direct plans offered by mutual funds generate marginally higher returns of approximately 0.5%  as commissions paid to distributors and financial planner is saved.

But on the other hand, in a bid to save 0.5% - 1%, you may end up losing heavily if your investment is not managed properly as sometimes your financial planner also provides expert advice and regular follow up on the fund performance.

 

 

VARIANTS OF EQUITY FUNDS

1. Large-cap funds – The scheme investing more than 65% of its assets into shares/stocks of companies that rank 1-100 in terms of the largest market capitalization. These companies are established players perform more consistently than mid-cap and small-cap companies and are comparatively safer. E.g. Reliance Industries, Infosys, Wipro, Bajaj Finance etc.

 

2. Mid-cap funds – The scheme investing more than 65% of its assets into shares/stocks of companies that rank 100-251 in terms of the largest market capitalization. These schemes are somewhat riskier than large-cap funds but stable as compared to small caps.

 

3. Small-cap funds – These schemes are the riskiest as they invest more than 65% of their assets into shares/stocks of companies that rank beyond 251 in terms of the largest market capitalization. These schemes are highly volatile and investors should restrict their investment to a very small proportion of their overall portfolio.

 

4. Sector Mutual Funds – These schemes invest in companies of a particular sector like banking, infrastructure, real estate, etc. These funds outperform when the market conditions and government policies for its respective sectors are favorable and vice-versa. Needless to say, the performance of the companies matters the most.

 

5. Equity Linked Savings Scheme (ELSS) – These are tax saving funds where the entire amount invested up to Rs. 1,50,000/- provides tax benefit under section 80C. These funds have a lock-in of 3 years.

 

6. Index funds – These funds invest in stocks that mirror or replicate a particular index on the exchange e.g. BSE Sensex, Nifty 50, etc.

 

7. International Funds – If you want to take exposure to the international market then you can consider investing in “International Funds”. These are also known as “foreign funds” or “feeder funds” that invest in companies located in other parts of the world. These companies could also be located in emerging economies. The only companies that it won’t invest in will be those located in the investor’s own country.

 

In this section, we will get a bit more into the details of index mutual funds.

 

 

IMPORTANT POINTS TO NOTE ABOUT INDEX FUNDS

The following are some of the important features of the INDEX FUNDS that every investor must know.

1. Investor’s profile – It is best suited to investors who have limited knowledge about market dynamics but have high aspirations of investing in the stock market.

 

2. Risk – Since Index funds mirror the index, it is less volatile in comparison to actively managed mutual funds.

 

3. Liquidity – Since Index funds are available in both debt or equity instruments, investors are advised to stay invested for the minimum of 5 to 7 years to cover multiple business cycles to make decent returns. However, it does not have a lock-in and in case of emergencies, it can be easily liquidated. However, if that happens during unfavourable market conditions, it can result in losses.

 

4. Taxation – Income earned from index funds is considered as “Income from capital gains”. Investment held for more than a year in equity oriented funds is considered as long term and returns earned up to Rs. 1,00,000/- is tax-exempt.

Short term capital gains on the other hand attract 15% tax on gains.

 

5. Volatile – Returns from mutual funds are market-linked which makes them volatile. The scale of volatility however, depends on the types of fund selected.

 

6. Time horizon – Index funds are more suitable for investors having a time horizon of at least 5 to 7 years.

 

7. Regular Income – Some dividend payout plans can help investors earn dividends as and when declared however, they are not guaranteed and subject to dividends being declared by companies they have invested money in.

 

8. Returns – On average, index funds generate CAGR ranging from -20% to 50% per annum.

 

9. Asset class – Index funds are available in both, debt and equity.

 

10. Cost – Fund houses charge expense ratio to facilitate mutual fund investments.

 

11. Loan facility – In case of emergencies, investors can pledge their mutual funds units as collateral to avail loan facility.

 

 

 WHO CAN INVEST IN INDEX FUNDS? 

• Indian residents.
• NRI.
• HUF or Institutional investors can invest in this scheme.

 

 

MINIMUM AND MAXIMUM INVESTMENT ALLOWED IN INDEX FUNDS

One can start investment with as low as 100/-. There is no upper limit.

 

 

 WHERE DO INDEX FUNDS INVEST YOUR MONEY? 

Index funds invest all their assets in buying the portfolio of stocks and bonds that forms the composition of the index that the scheme is replicating. For eg. Funds replicating NIFTY 50 will invest in portfolio of companies that NIFTY 50 comprises of.

These companies then use the money for managing their day to day operations and cash flow to ensure smooth functioning of its business operations.

The funds can be deployed towards executing their future growth plans, buying raw materials, repaying debts, improving infrastructure, expansion of business operations, payment of salaries, opening new branches, upgrading technology etc.

Any profit or loss arising out of the business activity is then shared with its shareholders and unitholders.

 

 

 WHAT KIND OF RETURNS CAN INDEX FUNDS GENERATE? 

Since index funds invest mainly in portfolio of bluechip companies, they are known for generating more stable returns as compared to any actively managed mutual funds. However, since they invest all their assets in buying stocks of a range of bluechip companies, it is more stable and its equity schemes can generate average returns of 12% to 18% if invested for more than 5 years.

Assuming, you invest Rs. 10,000/- per month until retirement (60 years) @ average rate of 12% per annum, the corpus you will create (approximately) on your retirement i.e. at the age of 60 at various age groups will be as follows:

 

HISTORICAL DATA OF RETURNS IT GENERATED

Below are some of the funds that have multiplied investor’s wealth in 5 years (2014-2019).

 

Returns Sensex has generated in the last 10 years

 

 

FUND ACCESSIBILITY AND LOCK-IN APPLICABLE FOR INDEX FUNDS

Mutual funds do not have any lock-in except ELSS tax saving funds having a lock-in of 3 years.

However, it should be noted that anyone with an investment horizon of less than 3 to 5 years should avoid investing in equity-oriented mutual funds as it may force you to exit with negative returns if withdrawn for any emergency during unfavourable market conditions.

 

 

 WHAT ARE THE BENEFITS OF INVESTING IN INDEX FUNDS? 

INDEX FUNDS offers the following benefits to its investors.

1. Expert Advice – One of the major benefits of investing in mutual funds is that you need not worry about choosing high-quality stocks and sectors to invest in. Successful equity investing requires a lot of research and knowledge. You need to dig deep into the financials of a company before you invest in it. Here, the fund manager does the job for you who is well qualified, understands the market dynamics and has competency in taking strategic investment decisions.

 

2. Risk Mitigation – By investing even a nominal amount in mutual funds, you can get exposure to several stocks. So, if you have Rs 2,000 in any equity fund, you will be able to buy stocks of various large-cap companies and lower risk of concentration. Further, since they invest all their assets in high quality stocks that comprises of portfolio of companies of a particular index, its returns are relatively more stable in comparison to actively managed mutual funds.

 

3. High returns – Equity funds are one of the options known for generating the highest returns which can easily beat inflation. Also, since your investment is diversified across stocks of various companies, the risk is minimized to a larger extent.

 

4. The most tax-efficient – Long term capital gains from equity oriented mutual funds up to ₹1,00,000/- per annum is tax-free. Anything in excess is taxed at the rate of 10% of capital gains.

 

5. Minimum lock-in with ELSS funds – Tax saving ELSS funds has the minimum lock-in of 3 years in comparison to all other tax saving options having a lock-in of at least 5 years.

 

6. Low cost – Low expense ratio with high growth potential as compared to insurance products, real estate and other actively managed mutual funds make index funds very attractive amongst the long term investors.

 

7. SEBI Regulated – Mutual funds in India are regulated by SEBI as their governing body. They restrict fund houses with their strict rules and regulations to keep their code of conduct and ethics in place and often protect investor’s interests from being compromised.

 

8. SIP – Systematic investment plan is available in mutual funds investments. It is one of the best ways of investing to take benefit of rupee cost averaging.

 

9. Easy access to funds during hard times – Mutual funds are highly liquid. During emergencies, the money can be withdrawn without any hassle whenever needed. However, withdrawing funds during unfavorable market situations may result in losses. Hence, one should refrain from investing in equity funds if they anticipate any expenses which may trigger redemptions.

 

 

 WHAT ARE THE LIMITATIONS OF INVESTING IN INDEX FUNDS? 

INDEX FUNDS have the following limitations.

1. Highly volatile and risky – Since the money is invested in buying shares and bonds of various companies, its returns are influenced largely by the performance of these companies which makes them highly volatile and uncertain in the short term.

 

2. No control over the choice of stocks – Since index funds are passively managed funds, the fund managers or investors have no control over selecting their favourite stocks. To take exposure to their favourite stock, one can invest directly or take PMS route.

 

3. No guaranteed returns – Returns from index funds are market-linked which make them highly unpredictable and uncertain.

 

4. Too many options – With the number of fund houses and options of funds that exist in the current scenario, investors are left confused with where to invest and how to choose the best fund and sometimes end up picking up the fund with very poor growth prospects. Hence, one should always take advice and use the knowledge of financial advisors.

 

 

 WHO SHOULD CONSIDER INVESTING IN INDEX FUNDS? 

INDEX FUNDS is most suited to the following investors:

1. Risk-takers – Young investors especially below 35 years of age with high risk appetite who can afford to digest negative returns, partially or fully to earn superior returns can consider this option.

 

2. Long Term Investors – Individuals investing for long term goals like retirement planning, children education, etc. who would not require funds for at least 5 to 7 years.

 

3. Young Investors – Those who have just started earning, unmarried and below 30 years of age.

 

4. High-Income Individuals – Investors who have the appetite to take risks of market volatility and fall under a higher tax slab of 20% or above can consider investing in equity oriented index funds due to its tax efficiency.

 

 

 WHO SHOULD AVOID INVESTING IN INDEX FUNDS? 

INDEX FUNDS may not be the best investment for the following investors:

1. Conservative Investors – Investors with very low-risk appetite, having a lot of family responsibilities and liabilities should avoid investing in this asset class as it involves huge risk due to its volatility including the risk of principal loss.

 

2. Investors with high liquidity needs – All market linked instruments especially, equities are highly volatile and suitable for long term investing of beyond 5 years only. Hence, frequent withdrawal at regular intervals is not possible. Hence investors with high liquidity needs should avoid investing in equities.

 

3. Investors nearing retirement – Investors nearing retirement should have very limited exposure to market linked instruments. Such investors may need funds in a very short duration and any market correction or fall can put their retirement planning at risk.

 

4. Senior citizens – Individuals above 60 years of age who are not willing to take any risk of market fluctuations and need regular income consistently should keep their exposure to equity very low.

 

5. Investors looking for regular income – INDEX FUNDS being a market linked instrument do not guarantee regular income to its investors. Any price appreciation in the value of the fund is added to its NAV and paid at the time of redemption.

Also, in case of dividend payout option, the dividend payout is subject to many conditions and paid to its investors only as and when declared.

 

 

 A PIECE OF ADVICE

THINGS YOU SHOULD DO WHILE INVESTING IN INDEX FUNDS 

INDEX FUNDS investors can consider the following suggestions while investing in this product to maximize the value of their investment.

1. Perform due diligence – Investors should be aware of all pros and cons of the investment they are getting into. The investment objective, the amount required on maturity, liquidity needs, risk appetite, etc. should be carefully assessed before signing up for this scheme.

 

2. Assess your risk appetite – One should always assess their risk appetite before investing in any market linked instruments. An asset class especially, equities are considered as a high risk – high return investment. Hence, investors with moderate income, sole bread earner of the family, low on savings, high on liabilities tend to have a very low-risk appetite as even a minor loss may derail their entire financial life. Such individuals should be very careful while investing in this option.

 

3. Know the pros and cons of investing in direct plans – Though investing in direct scheme is cost-effective due to lower expense ratio, it loses the edge in the form of expert advice and services of your financial planner. Their attention and expertise in the subject can help you achieve much better returns which may surpass the saving you would have had by investing in direct schemes. As it is rightly said, sometimes, saving pennies can cost you fortune. Hence, choose a regular plan provided your portfolio is being managed by a competent financial advisor.

Some broking houses also provide a user-friendly and robust online interface to help you keep track of your investments and manage them effectively. It not only gives you a single-screen view of all your investments across different fund houses but also lets you carry out transactions at your ease. The only downside of having a middleman or a broker is that it involves a higher expense ratio by a very small margin to accommodate their commission payout but that is small enough to make a significant difference to your investment kitty.

 

4. Know your investment goal – One should bear in mind all pros and cons of investing in mutual funds. Investment in market linked products is mainly meant for long term financial goals having a horizon of 5+ years.

 

6. Compare expense ratios – “Expense Ratio” refers to the charges involved in investing in mutual funds. Hence, always compare the expense ratio while investing, especially among the funds which are identical in all aspects and index funds. Hence, lower the expense ratio, higher the returns.

 

7. Always diversify – The safest way of investing is to diversify your risk across various sectors or companies. Concentration on one particular sector or a stock can be very risky and may result in loss of capital. Similarly, refrain from over diversifying the portfolio as it may dilute your overall gains.

 

8. Check entry and exit load – It is important to study every aspect of the fund while investing in mutual funds. An entry load is a onetime fee that you pay while investing in a scheme. Similarly, exit load is a fee you pay for exiting from the scheme before one year. Hence, if you anticipate any possibility of liquidating your investment before a year, invest in a scheme without the exit load.

 

9. Track your investments annually – It is very important to revisit your investment portfolio once every 6 months or at least once a year to review its performance. Its performance should be in line with its benchmark and other funds of similar nature. In case of any deviation, a decision needs to be taken after thorough analysis, whether to stay invested or to exit and look for a better performing fund.

 

10. Opt for online Platform – Always opt for a fund house or a broker whose online interface is strong and user-friendly. Investors should always use an online platform to better tracking mechanism and ease of transactions.

 

11. Update nominee details – Updating nominee details with the respective fund houses is very important. In case of an investor’s death, the family members should not end up running from pillar to post when they need that money the most to claim your investment proceeds.

 

 

THINGS YOU SHOULD AVOID DOING WHILE INVESTING IN INDEX FUNDS

INDEX FUNDS investors must avoid indulging in following practices while investing to protect their investment from losing its value.

1. Borrowing money to invest – A lot of brokers or agents will lure you with attractive returns however, one should understand the risk involved in market linked products. How much ever promising the investment looks, one must be very careful about fundraising methods. Never borrow money to invest in such instruments as these avenues are highly risky and there is a possibility where all your money can vanish if the investment fails.

 

2. Investing in direct schemes – Though investing in direct scheme is cost-effective due to lower expense ratio, it loses the edge in the form of expert advice and services of your financial planner. Their attention and expertise in the subject can help you achieve much better returns which may surpass the savings that you may have by investing in direct schemes. As it is rightly said, sometimes, saving pennies can cost you fortune. Hence, choose a regular plan provided your portfolio is being managed by a competent financial advisor.

 

3. Selecting the fund only based on past returns – Though past performance is one of the key determinants of assessing the fund’s credibility, it should not be the only deciding factor while picking up the investment. The glorious performance in the past can be a result of various factors that may or may not exist in the future. Hence, one should make a note of sectors the fund is exposed to, the track record of the fund manager etc. while making a decision.

 

4. Going heavy on small-cap or risky funds – Though small-cap and multi-cap funds are a very good vehicle to boost returns, one should not get over-enthusiastic and take heavy exposure to these funds as it may lead to over-concentration of a risky portfolio. It lacks stability and hence should only be looked at as a booster to other blue-chip funds.

 

5. Short term investing – If you see any possibility of redeeming the fund within 5 years of investing, avoid investing in market linked products, or take a small exposure. The reason is, to generate good returns, such avenues should be given sufficient time to cover multiple financial cycles involving market highs and lows and average out overall returns.

 

6. Do not get influenced by anyone but financial experts – A confused investor always has a tendency of reaching out to their friends and relatives for suggestions while making critical investment decisions. That happens irrespective of the knowledge and the level of understanding the friend has about the domain. It is as good as asking a truck driver, how to fly an airplane. Such advices in most cases are based on their individual experiences and hardly on calculations or facts and figures. Hence, instead of blindly following the financial advice of a random friend, investors must act wisely and take assistance of a well qualified financial planner who has sound knowledge about the domain.

 

 

WHAT ARE THE RISKS INVOLVED IN EQUITY INDEX FUNDS?

INDEX FUNDS investors should be mindful of following risks involved in this investment:

1. Currency Risk – International funds having exposure to foreign equity markets are more volatile due to fluctuations in dollar rates.

 

2. Market Risk – Returns on equity funds are market-driven and are largely influenced by various macro and microeconomic factors where we have almost no control. This makes this option highly volatile and so risky that its investors are exposed to a risk of losing their entire principal.

 

3. Liquidity Risk – Though money invested in equities can be withdrawn anytime, sometimes it is not financially viable to exit when the markets are on low. Doing so may lead to losses. Hence, one cannot rely on equities for their liquidity needs.

 

 

HOW TO SELECT THE BEST FUND?

INDEX FUNDS investors must follow the below instructions before signing up for the product to ensure the safety and growth of their investment.

1. Get to the roots of the fund history – Before investing, find out as much information possible about the track record and the past performance of the fund. One should religiously study the portfolio composition of the fund. Then study the financial statements like Profit and Loss statement, cash flow statement and balance sheet along with the credit rating of the company they are investing in. The company which is low on debt and high on operating income is usually preferred.

 

2. Study portfolio composition – When the scheme is focussed on a particular sector then the risk also gets concentrated on the performance of that particular sector. A slowdown in that sector can derail your overall investment. Hence, look for the fund that is evenly diversified across various companies and sectors.

 

3. Select technologically sound brokers – If you are investing through independent brokers then make sure they are well equipped with modern technology and systems. This will not only help you keep track of your investments online but also help you in making investments and redemptions yourself without depending on anyone.

 

4. Analyze performance – Where does the scheme stand against its competitors in terms of AUM size, market share, performance, etc. If the scheme has been in business for a while and still fails to build sizeable AUM or generate minimum returns against its benchmark and fellow competitors in similar schemes, then the reason for underperformance should not be ignored.

 

5. Assess liquidity requirements – Mutual funds are suitable for long term investors with an investment horizon of beyond 5 years as the fund has to go through multiple market cycles to be able to generate decent returns. Also, tax-saving ELSS funds come with a minimum lock-in of 3 years. Hence, investors with high short term liquidity needs should avoid investing in equities.

 

 

TAXATION RULES FOR INDEX FUNDS

Equity oriented funds

Income earned from the sale of equity mutual fund units is termed as “Capital Gains”. These capital gains are taxable in your hands depending on how long you stayed invested in equity funds. Such a period is called the “Holding Period”.

Capital gains earned on the holding period of up to one year are called “Short Term Capital Gains” (STCG). STCG is taxed at a rate of 15%.

Conversely, capital gains made on holdings of more than 1 year are called “Long Term Capital Gains”  (LTCG).  Owing to recent changes in budget 2019, LTCG up to Rs. 1,00,000/-  is tax-free however, over Rs 1,00,000/- will be taxed at 10% without the benefit of indexation.

Also, ELSS funds having a lock-in of 3 years provide tax benefit up to Rs. 1,50,000/- under section 80C.

 

Debt oriented funds

Income earned from the sale of mutual funds units is termed as “Income from Capital gains. However, the amount of tax applicable will be determined by the period of holding.

 If the investment in debt fund is held for less than 36 months then it will be termed as short term capital gains and anything beyond 36 months will be termed as long term capital gains.

Tax applicable in case of short term capital gains will be added to your total taxable income and will be taxed as per applicable slab. And in case of long term capital gains, the tax applicable will be 20% with indexation benefit.

 

 

DOES ANY OTHER PRODUCT OFFER BETTER PROSPECTS THAN INDEX FUNDS?

INDEX FUNDS can be beaten by the following products on various grounds.

1. From a safety point of view – Balanced funds, debt funds and MIPs being actively managed funds can be controlled by highly qualified fund managers especially when the volatility is high.

If someone is looking for an even safer bet than these then and are the best options.

 

2. From the returns point of view – Equity funds generate superior returns across most asset classes as they solely participate in the equity market.

If someone is looking for even better returns and has a high-risk appetite, then they can invest in or of various companies or properties.

 

3. From a liquidity point of view – Though mutual funds except ELSS funds do not have any lock-in period, accessing funds during emergencies can be a costly affair and withdrawing funds during unfavorable market conditions may result in losses. Hence, one should refrain from investing in index funds if they anticipate any expenses which may trigger redemptions.

Instead, investing in , or other like and can provide higher liquidity with more stable returns in the short term.

 

 

HOW TO INVEST AND DOCUMENTS NEEDED

1. The first and the most important requirement for investing in mutual funds is updating KYC details with the registrar. This can be done by submitting the KYC form with your PAN card and current address proof to the CAMS office or your investment advisor or AMC.

 

2. Then the profile needs to be created by updating your details with the registered broker or a fund house to open your account.

 

3. Once the account is opened, one needs to set up a user ID and password to register online or on mobile application and then start making transactions.

One time transactions can also be executed offline by filling a form of the particular AMC and issuing a cheque. To start SIP, the investor needs to sign the SIP mandate which specifies the amount and period of investment to set up auto-debit on the account.