What are index funds? Explained
Index means indices. Indices refer to a measurement of the price performance of a group of shares from an exchange. For example, NSE’s Nifty 50 contains the top 50 companies in India, and BSE’s Sensex contains the top 30 companies in India. Similarly, there are indexes based on the category of business like – Nifty Auto, Nifty Bank, Nifty FMCG, Nifty IT, Nifty Metal, Nifty Pharma, Nifty Realty, etc.
How can I invest in index funds?
- Make your own diversified index mirrored stocks portfolio.
- Make a small case inclusive of all index funds.
- Invest in an exchange-traded fund.
- Invest in an index mutual fund.
The first way to invest in index funds is by investing in all the companies manually. You need to do little research and allocate all the funds on your own. This would be expensive and requires much attention.
The second way is to make a small case and invest monthly in it. It will require a one-time setup but you’ll be buying at least a single unit of all the stocks, which is again expensive.
The third way is investing in an index ETF, which can be traded like a normal share. This doesn’t give you liquidity but offers you an option to invest in an index using single stock.
The above three methods require a DEMAT account to invest which comes with an AMC fee. So if you do not wish to use a DEMAT account for other investment purposes better try the mutual fund way.
The fourth and the most subtle way to invest in an index fund is via an index mutual fund. The mutual fund enables better liquidity and anyone including one with a low budget can invest in an index fund.
What are index mutual funds?
An index mutual fund is a type of “PASSIVE” mutual fund that replicates the index. In a simple way, the fund house collects money from investors and invests in the companies that make up the index.
The reason why index funds are called passive mutual funds is that the fund manager doesn’t need to make excessive research and find out the good stock; everything is set to mirror the index list.
Expense ratio in mutual funds.
Since it doesn’t require much effort for fund managers to manage index funds, the expense ratio is also lower compared to any active mutual funds. Expense ration is the charge or fee that fund house charges in order to manage the funds. The expense ratio of active mutual funds is higher than the expense ratio of passive mutual funds. Similarly, active mutual funds are less risky compared to passive mutual funds.
Exit load in mutual funds.
Exit load is a fee that will fund house collects from the mutual fund investment when you wish to redeem or withdraw it within a year or defined time limit. After a defined time limit it will be free.
But in the case of index funds, the time limit is just 3 days as it facilitates fast liquidity. This simply means, once invested in an index fund and waited for 3 working days, you can redeem or withdraw the funds without incurring the exit load of the fund house.
Usually, the exit load of an index fund is low like 0.2% while active mutual funds have around 1%.
Index fund investments are subject to taxation if you earn a profit on them.
This tax is divided like:
- STCG – Short Term Capital Gains (Less than a year).
- LTCG – Long Term Capital Gains (More than a year).
Short-term gains are taxed at a flat rate of 15%, there is no free limit to it.
Long-term gains are taxed at the rate of 10%, the first 1 lac is tx-free and indexation is not allowed.
Any losses can be carried forward to a max of 8 years. But you should file it in ITR each year.