Do you need to invest in index funds?

Read Time:2 Minute, 52 Second

Index funds are a type of mutual fund that track a market index. They are typically made up of bonds or stocks. These securities are grouped based on geography, business size, or the company’s niche. Investing in index funds is the best way for portfolio diversification and reaching long-term growth.

How do index funds work?

Index funds track a specific index. Thus, they work by investing in passive fund management. Passive management is where a specific index or benchmark is replicated to match its performance. The main purpose of passive fund management is to generate returns similar to a chosen index.

Therefore, when you invest in index funds, the money is used in companies that constitute a particular index and gives you a diverse portfolio. Index funds follow a benchmark index like Nasdaq 100 or S&P 500.

4 things to keep in mind before investing in index funds

Expense ratio

The expense ratio is the annual maintenance charge calculated on the scheme’s average Net Asset Value (NAV). Index funds, which are passively managed, have a low expense ratio as less work is required from the fund manager’s end. This is because there is no need to develop an investment plan or look for stocks to invest in.

Portfolio diversification

An index fund is a collection of various stocks and securities. You can purchase funds concentrating on businesses with small, medium, or big capital values or a particular industry, like technology or energy. Thus, using index funds, you can still be diversified within a sector if you believe a specific industry is likely to outperform the overall market.

Taxation benefits

As index funds fall under the equity category, your gains will be taxed as per the capital gains on equity schemes. Additionally, the holding term of the fund’s units affects the tax rate.

When holding units for less than a year, short-term capital gains (STCG) are levied. The amount of gain earned is taxed at a 15% rate.
Long-term capital gains (LTCG) are levied when a unit is held for more than a year. The rate is 10% without indexation benefits the advantage of indexation on the amount of gain realised, the tax rate is 10%.

Returns

Index funds are considered less risky because they are diversified. The only thing you need to keep in mind is the tracking error. Tracking error is the difference between the target index and the returns from the index funds.

High tracking error means a higher chance of risks involved and viceversa. Not just tracking errors, but ratios like the Sortino ratio and Sharpe ratio can give a good picture of risk-adjusted returns.

Should you invest in index funds?

Index fund investing has long been regarded as one of the best financial decisions you can make. Index funds are reasonably priced, provide for diversification, and produce enticing returns over time. Your returns will always be comparable to the returns produced by the index that serves as your index fund’s underlying benchmark. With a minimum of a three to five-year investment horizon, you can consider investing in an index fund.

Suppose you want to invest in a stock market index but need more time or expertise to manage the changing index and its weights for your investment. In that case, index funds may be a good option. Understand the investment mandate of the plan and its benchmark before comparing the performance of different funds.