With a net worth of more than $107 billion, Warren Buffet is one of the most successful investors of all time. Thousands of investors from around the globe tune into the annual general meetings of Berkshire Hathaway Inc. every year in hopes of getting in on some of Buffet's investing wisdom.
And the one investment advice that the Oracle of Omaha swears by for beginners is index funds. Index funds have emerged as one of the most accepted investment choices due to their low costs and steady returns. These are passive investments that invest in the stock of the index they are tracking.
Apart from being a prudent choice for portfolio diversification, investing in index funds is also the perfect way to lower your equity risk while maximising the returns. Whether you're a beginner or an experienced investor, index funds can be a profitable addition to your portfolio.
Here's everything you need to know about index funds and how to invest in them.
Index funds are a type of mutual fund that imitates the portfolio of an index. These are passively managed funds and their aim is to track and mimic the performance of stock market indices like NSE Nifty 50 or BSE Sensex.
A stock market index is an indicator of the performance of the securities market and includes stocks of diverse industries. So, the asset allocation of index funds will be the same as that of the underlying index. This means an index fund offers you the opportunity to invest in diverse sectors with a single fund earning comparable returns.
Under passive fund management, the traded securities depend on the underlying benchmark. So, unlike actively managed mutual funds, which are focused on beating the market, index funds are passively managed to match the performance of their index.
Consider an index fund that is tracking the BSE Sensex index. This fund will have the 30 (typically blue-chip) stocks in its portfolio that comprise Sensex in the same proportions. Simply put, the index fund will invest in all the securities (including equity and equity-related instruments and bonds) that the Sensex tracks. The fund manager will decide which stocks will be bought and sold based on the composition of the underlying benchmark.
When it comes to equity mutual funds, the fund manager uses his discretion and past experiences to pick an investment strategy for the fund.
However, since index funds are passively managed and mimic the performance of the underlying index, they overcome this human bias. The fund managers don’t have to rely on their judgement to make investment decisions. The fund only tracks the benchmark index and possibility of human error is eliminated.
The expense ratio is the percentage of the money you are paying to the AMC for running and managing your mutual fund investments. Since index funds are passively managed, they feature a relatively lower expense ratio. Their asset allocation remains almost the same for the entire period because any change in its composition will only happen when there is a change in the asset allocation of the underlying asset.
Investing in index funds helps ensure your portfolio is exposed to a range of high-performing assets and industries for maximum diversification. It spreads your investment across a wider market segment and market-cap categories, which effectively distributes the risk and brings good returns in the long term.
You can easily invest in index funds through a hassle-free process as you don't need a Demat account for the same. You can apply online via a secure platform like Tata Capital Wealth or apply directly by visiting the nearest AMC branch of the preferred fund. The offline process will involve the submission of necessary documents along with the payment to get started with the investment.
Here is the step-by-step process to invest in index funds online-
Step 1: Sign up for a mutual fund account via a reliable platform like Tata Capital Moneyfy.
Step 2: Complete the KYC formalities if not done yet.
Step 3: Fill in the necessary information.
Step 4: Based on your financial needs and investment objectives, compare various index funds.
Step 5: Pick suitable index funds and buy units with a single lump-sum payment.
Step 6: You can also opt for a SIP plan with standing instructions for your bank.
Here are some key benefits of investing in index funds:
1. Tax benefits: Index funds don't actively trade in securities like active funds. As a result, they are more tax-efficient and help increase your after-tax returns.
2. Lower expense ratio: Since index funds are passively managed, they come with a lower expense ratio. This results in lower fees for investors, allowing you to receive more of the returns.
3. Manageable: Index funds are easy to manage as they automatically track a specific market index. This eliminates the need for constant monitoring and decision-making.
4. Impartial investing: Index funds replicate the performance of an entire market index without focusing on specific stocks, removing biases.
While index funds are a lucrative investment option, it's important to consider some key factors before investing:
1. Risk and returns
Since index funds replicate the performance of a specific market index, their returns are typically aligned with the index. While this does make them less risky compared to actively managed funds, they are still subject to market risks and volatility. Therefore, it's important to remember that index funds will mirror both market gains and losses and invest as per your risk tolerance.
2. Expense ratio
The expense ratio is the fee levied by the fund to cover management and operation expenses. Index funds typically have a lower expense ratio compared to actively managed funds since they require less oversight. However, it's important to verify the expense ratio of a fund before investing as even a small difference can significantly impact your returns.
3. Investment plan
Before you invest in index funds, make sure to have a clear investment plan. This includes your financial goals, investment horizon, and risk appetite. This will help you identify the best funds that align with your requirements and make informed investment decisions.
4. Taxation
Since index funds are equity funds, you may be subject to dividend distribution tax (DDT) and capital gains tax. Fund houses deduct a 10% DDT at source before releasing dividend payments. Moreover, if you sell the funds within a year, you'll have to pay a short-term capital gains tax of 10%. If you sell the units after a year, long-term capital gains tax of 12.5 % will be applicable on gains exceeding Rs. 1.25 lakh.
Index fund investments are an excellent way to get exposure to a diversified portfolio while minimising your risk and boosting your returns in the long run. If you're ready to take your first step towards index fund investments, look no further than Tata Capital Wealth.
Our financial experts will assist you in comparing, identifying, and investing in the best mutual fund schemes to grow your wealth seamlessly. Visit our website today or download our investment app to know more.
If you plan to invest in index funds for a long time, considering short-term market highs and lows isn't necessary. The longer you stay invested, the greater the compounding you can enjoy.
Like any other fund, index funds can also lose money. But if you stay invested for a longer period, your investments will have a better potential to grow.
Yes, index funds can be a good investment for the long term. They are affordable, diversified, and aligned with the index.
To index smartly in index funds, select an option that aligns with your risk tolerance, investment horizon, and financial goals.
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21 September 2024
7 mins read
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