What is an Index fund, and how to choose the best Index Fund?

Let’s understand the concept of Mutual funds before jumping into index funds. Mutual funds are a collective investment of several investors managed by a person called a “Fund Manager.” They all come together to invest their money in the various assets of the market to increase their wealth. Such an asset’s value starts gaining value when the demand in the market increases. On the contrary, if the supply of that particular asset increases, its value starts reducing. The loss or gain in the asset’s value determines the NAV, “Net Asset Value,” which determines the investors’ profit or loss. Index Funds are also mutual funds with an index as their underlying asset. 

What are index funds?

You must have heard about NSE Nifty and BSE Sensex in the finance news. They are nothing but indices that represent the overall market behavior. An index fund is like any other mutual fund but works based on these indices. The top index funds in India track the performances of these indices and give returns similar to that of the benchmark index, which they follow. As a consequence, they contain the same stocks as the index in the same proportion. Index funds are passively managed funds because the fund manager has no work unless there is a rebalancing requirement. There can be marginal tracking errors. So the returns will be similar or closer to the index and not equal to it.

Advantages of Index Funds:

  • The best index funds have a less expense ratio because the fund manager has almost no work unless there is an addition or removal of the stocks that comprise the index.
  • They are mostly moderately high-risk funds without much price fluctuations. It means stable returns.

Factors to be considered while choosing the index funds:

The best index funds in 2022 can be chosen by assessing certain factors before investing in any fund.

1) Returns on Investment:

Before investing in any index fund, choose scheme plans with the least tracking error because the lesser the errors higher are the returns. These funds attempt to match the index’s performance by passive tracking. Even while index funds face similar risks as any other investment, the chances are better that your investment will grow in value over time, and you can sell your investment for a profit.

2) Risk on Returns:

The best investment strategy in a trending market is index funds. When the stock market goes down, it is vice versa. Since index funds try to match the index’s performance, they are less vulnerable to equity-related volatility. But when the market is in bearish sentiment, actively managed funds are needed to adjust the risks. A balanced portfolio is a wise way to go ahead when it comes to capital growth plans that index funds offer.

3) Expense Ratio:

Index funds have the lowest expense ratio. The deduction of expense ratios is in proportion to returns. Even though Index funds mimic the performance and composition of indexes, there are always fees involved with purchasing and selling shares. Compared to actively managed funds, they have lower operational costs. The fund manager of most index funds is devoid of designing an investing plan. If two index funds track the Sensex, their performance will be the same with the only difference in expense ratio. Top index funds have the lowest cost ratios and provide superior returns.

4) Trade Cost:

The cost of trading in a mutual fund is higher than in stocks and ETF trading. Compared to mutual fund institutions, some brokers offer a great deal. So when buying a mutual fund, beware of sales loads, which might remove some percentage of your contribution before it’s invested. They are avoidable by using broker-offered funds. When it comes to index funds, these charges are less, as the number of trades placed will be much lesser compared to an actively managed fund.

5) Long-term:

For people who prefer long-term investments, index funds like VSMAX or Vanguard Small Cap are the best choice. The fund value can change quickly in the short term, but the returns start stabilizing over time. People who buy index funds must be willing to put their money away for a long time if they expect a 10 – 12% return. Over this period of 7 years, with a 10% return, you can make your investment double.

6) Retirement Plan:

Suppose your goal is to build wealth and peacefully retire at the desired  age. Learn how to invest in index funds. Index funds can give good returns in the long term without many risks. You can enjoy your retirement life as planned without any hiccups with an investment in index funds.

Tax on Index Funds:

Taxation of index mutual funds is no different than of the equity. The holding period decides the taxation percentage.

Short term:

15% tax is levied from the gains if you sell off your units within one year, and this tax is called short-term capital gains tax.

Long term:

If you hold your units for more than one year and then sell them off, you can avoid tax if your overall gain is within Rs. 100000. 10% tax is applicable for capital gains above 1 lakh. It means a profit of 1 lakh is exempted from tax. Any gain over 1 lakh will be taxed at 10%.

For instance: If you earn Rs. 1,50,000 from an index fund, by holding and selling it after 12 months, you are liable to pay a tax of 10% on Rs. 50,000 only.

There is one more tax called Dividend Distribution Tax. If you are a person whose annual income exceeds Rs. 5 lakh, there will be a 30% tax on the dividends you get from your index fund.

Conclusion:

Index funds holders are more advantageous compared to other mutual funds or trading instruments regarding the safety of your capital. Since it has a relatively low risk, the gains are also low. But in the long run, you can expect ample returns. Different companies manage several index funds in India. If you carefully analyze all the factors mentioned above, you can select the best index fund to invest in as per your needs.

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