How Index Funds Work: If we look at the trend of the last few years, the focus of investors is increasing on index funds. For this reason, most mutual fund houses have also increased their focus on index fund products. Recently many NFOs have come in this category. For investors who want to take advantage of equity investment with low risk, index funds can prove to be a good option. Talking about the index, Nifty 50 has given an overall absolute return of 97 percent in the last 5 years and an overall return of 240 percent in the last 10 years. Here, Neeraj Saxena, Fund Manager and Dealer – Equity, Baroda BNP Paribas Mutual Fund has given important information regarding index funds.
1. What are index funds?
Index funds are a type of mutual funds that track a specific benchmark index. Their list can range from broad market indices like Nifty 50, Sensex to sector based indices like Nifty Bank, Nifty IT.
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2. What is an index?
Talking about stock market index, it shows the performance of the stock market. It helps investors gauge the performance of the broader stock market by comparing the current level of the index with the previous level of the index.
3. How do index funds work?
An index fund tracks or attempts to replicate the performance of a particular index by investing in securities whose index components have weights similar to the weights of the securities included in that index. The index provider calculates the daily weights of the securities in the index and releases the file to the AMC, who then use the file to rebalance their portfolio and align it with the index.
4. What are the benefits of index funds?
a. These make it easier to understand the investment strategy. Closely tracks pre-specified benchmark/index. Or perform like that.
b. Index is a rules-based portfolio, in which stocks/companies are selected based on pre-defined rules and is free from any personal bias.
c. A portfolio reflecting the collective wisdom of the market with market performance subject to tracking errors and expenses.
d. Generally lower expense ratio than active mutual funds due to no active movement of the fund manager in investment decisions.
e. Index funds are required to strictly replicate the index as per regulations and no active decisions are taken by the fund manager in the selection of securities.
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5. Why are the management costs of index funds lower?
Index funds do not require any active stock selection or investment decisions by the fund manager. This eliminates the time investment and research requirements of the fund manager. Additionally, index funds involve less buying and selling of units for short-term profits as compared to active funds, thereby saving on transaction costs. These costs, which form a major part of a fund's expense ratio, are virtually eliminated. That means the expense ratio is less in index funds.
6. Who should invest in index funds?
Index funds are an easy and affordable investment option for all types of investors. New investors may benefit from considering the low costs and variety of benefits offered by index funds, as well as their extremely easy-to-understand structures. Experienced investors may benefit from using index funds to gain market cap exposure or exposure to certain index strategies.
7. What is tracking error?
Tracking error is a measure of the difference in a fund's returns from the benchmark return (the gap between the observed value and the expected value). Tracking difference calculates point to point returns and reveals the difference in returns between the fund and the index. In contrast, tracking error calculates the standard deviation of the daily difference in performance between the fund and the index and represents an annual number, known as tracking error.
8. How to invest in index funds?
An investor can invest in index funds in the same way as a normal mutual fund, i.e. by submitting an application to the AMC either online or offline i.e. physically. Apart from this, an investor can also contact his distributor or relationship manager for investing in index funds. One can use the latest fintech platforms to invest in index funds.
9. What are the risks associated with index funds?
The key risks associated with index funds remain the same as any traditional mutual fund investing in the same asset class. All equity funds including equity index funds will be subject to similar risks and the same applies for debt index funds. Additional risks associated with index funds include:
1. Tracking Error
2. Tracking Difference
3. Index related risk
4. Index Dissolution Risk
5. Management risk in which the fund may not be able to perfectly replicate the index
6. Risk of concentration
7. Passive investment risk, in which the fund manager invests in the securities included in the index without regard to their investability.
10. How are index funds taxed?
Index funds are taxed based on the asset class in which they invest. Equity index funds are taxed as per the tax rules applicable to equity and debt index funds are taxed as per the tax rules applicable to debt.