A beginners’ guide to Index Funds. How it helps in creating wealth (2024)

Index funds are a type of mutual fund designed to replicate the composition of stock indices. Unlike actively managed funds where the fund manager makes individual stock selections, index funds are passive. The fund manager’s goal is to mimic the portfolio of the underlying benchmark index.

For example, if you invest in an index fund tracking the Nifty50 index, the fund manager allocates investments across the same 50 stocks featured in the index, following their proportional representation accurately. As a result, the performance of the index fund closely follows the movements of the index. Whether the index rises or falls, the fund’s performance reflects these changes in an equal manner.

Index Fund Returns

Returns are the most important aspect of any investment, and equity index funds have provided reliable returns over the decades. This is because the indices have multiplied investor wealth manifold. Historically, they have outperformed many actively managed funds as well. Some of the prominent index funds have given an average annual return of around 12-14% over the last two decades.

Costs of Investing

When it comes to investing in mutual funds, it is important to keep costs in mind. The expense ratio is the fee for managing your investment funds. For index funds, this fee is low compared to other types of funds that have someone actively making decisions about where to invest. It is lower because with index funds, there is not much need for constant decision-making. So, they are often called “low-cost funds.”

To give you an idea, some index funds have fees as low as 0.3 per cent to 0.30 per cent. On the other hand, if you go for actively managed funds, they can charge you more, usually somewhere between one per cent to 2.80 per cent of what you have invested. In simple terms, index funds are great because they keep these costs low, making them a smart choice for many investors.

Investment Amount

Whether you are an investor embarking on your investment journey or a pro-investor, index funds welcome all with open arms. You can start with as little as Rs 500.

Taxation

Taxation plays a crucial role in evaluating any investment. When it comes to index funds, they are treated in the same way as equity funds. Profits generated from index funds are categorised into long-term and short-term capital gains. If the fund is held for up to 12 months, the gains fall into the short-term category and are subject to a 15 per cent tax rate.

On the other hand, gains from funds held for over 12 months are considered long-term and taxed at 10 per cent. Notably, long-term capital gains of up to Rs one lakh annually are exempt from taxation. Additionally, any dividends received are added to your income and taxed according to the applicable slab.

Who Should Invest in Index Funds?

Index funds are a good choice for people who are new to investing or prefer lower-risk options. They provide exposure to the stock market without too much risk. If you are okay with the returns that the overall market gives, then index funds are a good fit. It is wise to keep your money in index funds for at least 5-7 years to get the most benefits because the market typically goes through cycles that last 6-8 years.

If you want higher returns, then you may diversify and invest in actively managed funds. Do note they cost more but are managed by fund managers who actively pick and choose investments, aiming to outperform the market indices.

Index funds help your investment grow proportionally by betting on the market’s overall growth trajectory. You do not need to stress over market timing. Moreover, it’s always good to have a diversified portfolio as per your financial situation.