Index Fund: What Is It And How It Is Different From Other Active Mutual Funds; Check Details

Index Fund for Low Risk High Return Investment: For long term wealth creation, investment in equity i.e. stock market is included among the best options. But investing in equity also involves more risk. Especially for investors who do not have complete knowledge of the complexities related to the stock market. If such investors want to get better returns by taking little risk, then they are generally advised to invest in mutual funds. But there are different types of mutual funds available in the market. Therefore, choosing the right fund may seem difficult for new investors. In such a situation, index funds can prove to be a good option for investors who want to take advantage of equity investment at low risk. Nifty 50 has given an overall absolute return of 84.73 per cent in the last 5 years and an overall absolute return of 225.35 per cent in the last 10 years.

What is Index Fund?

Before understanding the meaning of Index Fund, you should have basic knowledge about index. There are two major exchanges for buying and selling of shares in the Indian stock market. First is National Stock Exchange (NSE) and the second one is Bombay Stock Exchange (BSE). The different companies listed in these have been divided into many different indices, so that it is easier to monitor their trends. There are many indices based on the market capitalization of different sectors or companies. But the most prominent index of NSE is Nifty 50, which is also commonly called just Nifty. It includes the 50 largest companies listed on the National Stock Exchange. Similarly, the most popular index of Bombay Stock Exchange is Sensex, which includes the 30 largest companies listed on BSE. The weightage of each company in the index is different.

Index Fund follows the index 

Now let's talk about index funds. There are many mutual funds whose money is invested only in the companies included in a particular index. Because of this, the movement of that index fund follows the same index in which it has invested money. That means, all the money of Nifty 50 index fund is invested in the companies included in Nifty 50 only. That too in proportion to the weightage of the companies in that index. That is, if a company has 10 per cent weightage in the index, then 10 per cent of the amount of that index fund will be invested in the shares of that company.

Why index funds are also called passive funds?

A special thing about index funds is that since the investment formula is already decided in it, no fund manager has to decide how much money to invest in a share. That is why index funds are also called passive funds. Being a passive fund, it saves on expensive fees/commission paid to fund managers. This is the reason why the expense ratio (Total Expense Ratio) of index funds is much lower than other funds. Due to which the scope for improving the net returns received by investors increases. In active funds, mutual funds are managed by fund managers. The asset management company (AMC) charges expenses up to 2 per cent through expense ratio, in index funds this expense usually ranges between 0.5 per cent to 1 per cent.

Less risk, more return in Index Fund

Index funds are also considered to be less risky than other mutual funds. The main reason for this is that major indexes have generally been continuously moving upwards over a long period of time. For example, Nifty 50 has given an absolute return of 84.73 per cent in the last 5 years and 225.35 per cent in the last 10 years. Similarly, BSE Sensex has given an absolute return of 84.55 per cent in the last 5 years and 220.99 per cent in the last 10 years. The record of Nifty Midcap is even better. This index has given an absolute return of 143.92 per cent in the last 5 years and 455.62 per cent in the last 10 years. Here, let us also tell you that along with the return on investment in midcap index, the risk is also high, hence only those investors who have high risk appetite should invest in it.

Easy to diversify portfolio

By investing money in index funds, it also becomes easier for small investors to diversify their portfolio. This reduces the risk of loss, because if the shares of one company fall, the loss is often quickly compensated in another company. Due to low expense ratio, the net returns in index funds are likely to be better than active funds.

Who should invest in Index Fund?

For mutual fund investors who want good returns with minimum risk, index funds can be the right option. The money invested in it is not invested as per the wisdom of a fund manager like active funds, rather its formula is already decided. Therefore, choosing the right index fund is comparatively easier. For example, those who want to take less investment risk can invest in Nifty or Sensex-based index funds that invest in top 50 or top 30 companies. Investors who have the ability to take more risk for higher returns can invest in funds based on midcap index.

How much tax is levied on Index Fund?

Index funds generally invest in equities, so investing in them gives all the benefits that are available on Equity Oriented Funds (EOF). For example, short term capital gains (STCG) tax at the rate of 15 per cent has to be paid on profits made if investments are withdrawn in less than 12 months. At the same time, if the profit on selling after holding for more than 12 months is more than Rs 1 lakh in a year, then Long Term Capital Gains (LTCG) tax is levied at the rate of 10 per cent. That means no tax has to be paid on long term capital gains up to Rs 1 lakh.