A Beginner's guide to Index Mutual Funds...

If you remember your school days, you might recall how our class teacher would select a student to be the class monitor. This class monitor would be an ideal student who is smart, talented, reliable, disciplined, and someone who is the best representative of the whole class. On the other hand, every class had those mischievous kids who always forgot to complete their homework and copy it from the class monitor last minute. Now compare this class monitor to a stock market index which represents a specific number of the best-performing stocks listed on an exchange like NSE’s Nifty 50 and BSE’s Sensex. And now compare the mischievous kid to an Index Mutual Fund, who is always copying every move of the stock market index. Interesting, right? Curious to learn more? Let’s unfold this concept as you read ahead...

What is an Index Mutual Fund? 
An Index Mutual Fund creates a portfolio by replicating a stock market index. To put it simply, this fund consists of all the stocks that are a part of a particular stock market index. Even the weightage of a stock in an Index MF is the same as its weightage in the Index. Say, if Reliance Industries has 10% weightage in Nifty 50, then a Nifty Index Mutual Fund’s portfolio will also give 10% weightage to Reliance Industries. Hence, this fund tries to mirror a market index and generate the same returns as an index over a period of time

Since these funds try to replicate the performance of an Index, they are passively managed. Here, a fund manager does not need to research & analyze stocks to be picked for their portfolio because these funds comprise of all the stocks forming an Index in the same proportion. On the other hand, actively managed funds require extensive tracking and research on the fund manager’s part. Also, actively managed funds try to beat their benchmark index whereas passively managed funds like an Index fund try to imitate an index’s performance. Hence, passively managed funds attract a low expense ratio compared to actively managed funds as fund management cost is less.

Things to be considered before investing
a. Risk & Return
These funds have low volatility than actively managed funds as they are based on an index. Thus, they carry low risk. Index MF could gain you promising returns if held for the long term say between 7 to 10 years. By now you might have realized that these funds will gain good returns only when the markets are rallying. A short-term slump won’t hurt your gains as your investment horizon is for the longer term and the market averages out. Additionally, this fund act as an effective diversification tool for your portfolio as it would invest in all the best-performing companies and sectors in an Index.

b. Tracking error
A fund manager tries to deliver similar returns as the Index but to err is human. This difference between an index’s performance and an Index funds’ performance is called the Tracking error. So, we need to choose a fund with the lowest tracking error record and more or less similar performance to its index.
c. Tax
We all are aware that our capital gains attract tax. For a holding period of up to one-year, Short term capital gains (STCG) tax is applicable at a rate of 15%. Similarly, for a holding period of more than one-year, Long term capital gains (LTCG) tax, on gains above Rs 1 Lakh, is applicable at a rate of 10% without indexation benefit. 

Who should invest?
If you are someone who has a low-risk appetite, this fund is your new best friend. It is also popular amongst newbie investors who have little or no knowledge about markets but are keen about investing and creating wealth for themselves in long run say, for retirement. It is also one of the new favorites of investors as they cost lower than actively managed funds. If you are a student, you can also start SIP for this fund and gradually build your way up.

Bottomline

Diversification, Low risk, low cost, and returns almost at par with a market index, what else can an investor ask for, right? 
Index MF is a safe haven for smart investors. It is important that you understand your financial goal, risk appetite, and investment horizon before you make any investment decision. Although these funds are passively managed it is crucial that you analyze and compare various index funds being offered in the market

Wishing you all a Happy new year! I hope your 2021 is filled with a lot of “Fun-nance” learnings and good investments.

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