Passively Managed Mutual Fund: Index Funds

Index funds are open-ended funds where the expense ratio is least and the return are in line with the market index which they propose to replicate.

Some investors prefer indirect investment to direct investment in equities. For this class of investors, the best passive strategy could be buying into an index fund. Here, the fund manager pools the resources of several investors and invests in stocks that comprise the index in the same weightage as in the index. These funds are designed to duplicate as precisely as possible the performance of some market index.

These funds are passively managed as fund managers do not play an active role in selecting the security and articulating the strategy. Fund managers match the investment with the underlying index. For example: If the underlying index is Nifty 50, then the portfolio of the index fund will consist of 50 stocks, replicating the same stocks in the same proportions due to which the expense ratio of these funds is lower as compared to actively managed funds. Tracking error shows an investment's consistency versus a benchmark over a given period. So, funds with minimum tracking error are best to invest.

Now the question arises of how to choose an index fund? Firstly, you should decide which index you are willing to track and want to replicate the returns of the same. Secondly, search for mutual funds tracking the same index then compare these funds based on their tracking error and expense ratio. The fund having the lowest tracking error as well as expense ratio can be an ideal fund for you to park your funds.

Investors must consider the following pointers before investment:

Risk capacity: As these funds are a reflection of the underlying index, investors, who are ready to take risks should invest in these funds as there is the market as well as volatility risk.

Cost: Index funds usually have a low expense ratio as compared to actively managed funds, which leads to generating more returns. Index funds generate similar returns as benchmark indices; sometimes, there can be a difference, which is known as ‘tracking error’. Here again, the question arises - Which index fund should you choose to invest in? Ideally, you should choose an index fund, whose expense ratio as well as tracking error is lower.

Investment horizon: Ideally, investors, who are ready to invest for the longer term should choose to invest in these funds as they offer sound returns if invested for a longer-term (i.e. at least for 7 years) than short-term investors as in short-term, fluctuations are experienced.
 

Taxation: You earn capital gains on the redemption of units of the index funds. If you were invested for the shorter term i.e. up to 1 year, then the tax rate will be 15% on short-term capital gains (STCG). If you were invested for the longer-term i.e. for more than 1 year, then gains up to 1 lakh will be exempted and any gains above 1 lakh will be taxed at 10% on long-term capital gains (LTCG).