Index Mutual Funds: Everything You Need To Know Before Investing

Growing concerns about the fund managers’ ability to successfully generate optimal yields on mutual fund investments and the high valuations of equity markets have further strengthened the case of index funds as opposed to active funds. In this article, we will try to cover everything you need to know about index mutual funds before you consider investing in these funds.

What is an index fund?

Index funds are a type of mutual fund that track a commodity, an index, bonds, etc. Simply put, index funds are passively managed mutual funds that aim to replicate the performance of their underlying indices such as the CNX Nifty index fund or the BSE Sensex nifty fund.

How does an index fund work?

As index funds aim to mimic a particular index or market segment, these funds follow a passive style of management. As a result, the portfolio of index funds always mirror the portfolio of their underlying index, both in the percentage holding and choice of stocks. Due to this correlation, the NAV (net asset value) of index funds move closely in line with the NAV of the index it mirrors, subject to tracking errors. For instance, if the NAV of a particular index, say CNX Nifty drops by 10% over time, the NAV of the Nifty-linked index fund is also likely to decline roughly around 10% over the same period.

Benefits of investing in an index fund
There are certain advantages enjoyed by investors by investing in index mutual funds. Here are a few benefits of index funds:
1. Low management fees – Index mutual funds are passively managed mutual funds They are designed in such a way that the scheme tries to generate returns similar to the underlying securities that comprise the benchmark. This results is low management fees which further leads to a low expense ratio.

2. Fund manager bias/risk eliminated – Passive investment style follows a computerized, rule-based investment technique. This eradicates human discretion/bias while investing in index funds.

3. Broad market exposure and diversification – Index funds help investors diversify their investment portfolio across sectors and stocks. As major stock indices are created to represent the overall market, they cover all significant sectors and stocks of the economy. For instance, if you invest in an index fund that tracks the BSE Sensex index fund, you are likely to enjoy exposure to 30 stocks across 11 sectors ranging from communication services to pharma, etc.

Who should invest in index funds?
Index mutual funds may be ideal for those investors who wish to invest for a longer duration and generate wealth through equities but are cynical about the role played by fund managers. These mutual funds might be suitable for risk-averse investors who expect predictable returns on their mutual fund investments. Having said that, an investor must invest in index funds after careful analysis of their financial goals, risk profile, and investment horizon.

Tax aspect of index funds
As index funds fall under the class of equity funds, index mutual funds are taxed similar to equity mutual funds. Just like any other types of mutual funds, index funds are subject to dividend distribution tax (DDT) and capital gains tax.
Dividend Distribution Tax
The dividends offered by index mutual funds are added to the overall income of the investor and taxed according to the income tax slab of the investor.
Capital gains tax
When an investor redeems their mutual fund units at premium rates, they earn capital gains that are taxable in the hands of investors. The rate of taxation is dependent upon the holding period of the investments. Equity funds that are held for a period of 12 months or less are termed as short-term investments. On the other hand, investments held for more than 12 months are termed long-term investments. Short-term capital gains (STCG) on equity funds are taxed at 15% per annum. Conversely, long-term capital gains above Rs 1 lac per annum are taxed at 10% p.a. without the benefit of indexation. Long-term capital gains of up to Rs 1 lac on equity funds are tax free.

Mutual Fund Investments are subject to market risks, read all scheme-related documents carefully.