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What are Index Funds? Lesson 1-Oh-One

What is an index fund?

Let’s imagine you found a great recipe on YouTube. The ingredients and their proportions are all the same but you change the quantities to suit your taste buds. Investing in an index fund is quite similar. You’re effectively putting your money in all the stocks listed on an index in varying proportions. Let’s go into this in a bit more detail.

In simple terms,

- Index funds are a type of passive mutual fund that mimics the performance of a market index like the SENSEX or NIFTY 50

- Here’s the main difference — if you choose to invest in all the stocks listed on an index directly, you’ll need more than 1 lakh. An index fund allows you to buy the same stocks for as little as INR 500!

Why should you invest in index funds?

- Because of their passive nature, index funds require a lesser degree of human intervention

- As a result, they are cheaper to buy

- Data shows that most investors as well as actively managed funds are not able to beat the return from the index in the long term. This makes index funds a popular choice

- Index funds are a great place to start if you’re new to investing

- They’re best suited for long-term (more than 5 years) investments

- They have a low portfolio turnover. In other words, shares of companies tracked by indices don’t change often so buying and selling of company shares takes place less frequently

- They have low expense ratios. This means that you’re giving away less money in management fees

- In contrast, actively managed funds aim to beat an index’s performance. Buying and selling of shares takes place more frequently and as a result, actively managed funds have higher expense ratios

How do index funds work?

India’s stock market basically has two benchmark indices — NSE Nifty and the BSE SENSEX — with additional broader market indices such as Nifty 50 and BSE 100, sector-specific indices such as Nifty FMCG, Nifty Bank Index, and Nifty IT. But indices aren’t limited to stock markets alone. They can also have debt instruments such as government securities, treasury bills, and corporate bonds, among others.

All that an index fund does is put your money in units.

· Each unit contains stocks in proportions as listed on a particular index

· Those proportions could either be according to companies’ market capitalization or have equal weightage irrespective of their market cap.

We’ve talked about this in greater detail in Part 2, so check it out here[VR1] !

Are index funds right for you?

If you want to invest without actively tracking your investments’ performances week after week, index funds are a decent choice but they’ll only deliver great returns if you plan on holding them for more than at least 5 years. No company is able to turn a profit overnight and the world is pretty unpredictable at times, so the longer you hold on to index funds, the better your returns will be.

Time in the market is always better than timing the market.

How should you invest? All at once or bit by bit?

Great question! In truth, either way is fine but if you like to be cautious, you could take the SIP route and go with a sum for as low as INR 500 per month.

Will you be taxed?

Yeah. Your income from dividends and capital gains (if you redeem your investments). These are of two kinds.

Long-term capital gains: If you sell your index fund units 12 months after your first purchase, you get taxed at 10% on your gains without any indexation benefits.

Short-term capital gains: If you sell your index fund units before 12 months since your first purchase, you get taxed at 15% on your gains without any indexation benefits.

In short?

- Index funds basically track the top companies listed on a stock exchange or debt assets with a good credit rating

- Essentially, you’re buying high-quality stocks for low prices

- Index funds help you with diversifying your investments and carry lesser risk over a longer period of time as opposed to investing in a single stock

- Human error in mimicking returns from an index is minimal due to analysis by advanced computing systems

Want to know more about index investing? Stay tuned for our next article in this series on how to choose a solid index fund!

Time for some SALT Factoids!

Index investing actually started in 1976 with the Vanguard 500 fund by John Bogle in the United States. This approach also became known as passive investing where index movements were mimicked into a portfolio with little attention given to its composition. Vanguard Group’s Indian counterpart, IDBI Principal, launched India’s first-ever index fund in 2001.

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