How to Invest in Index Funds (2024)

An important component of a successful investment portfolio is diversification. Investors try to spread their money among a variety of asset classes, including gold, real estate, debt, and equity. To reduce risks, they work to further diversify even within each asset class.

By purchasing shares of companies with various market capitalizations and sectors, you can diversify your equity portfolio, a well-known strategy for lowering risks in equity investing. Index Funds come into play here.

In this blog, we'll discuss Index Funds, how to invest in Index Funds.

Understanding Index Fund

An Index Mutual Fund, as its name implies, makes investments in stocks that mimic stock market indices like the NSE Nifty, BSE Sensex, etc.

These funds are passively managed, which means the manager doesn't alter the portfolio's composition and instead invests in the same securities that are present in the underlying index in the same proportion. These funds aim to provide returns that are comparable to the index they follow.

How Do Index Funds Work?

Let's say that an Index Fund is tracking the NSE Nifty Index. This fund will, therefore, have 50 stocks in its portfolio in similar proportions. An index can include equity and equity-related instruments along with bonds.

The Index Fund ensures that it invests in all the securities that the index tracks. While an actively managed mutual fund endeavours to outperform its underlying benchmark, an Index Fund, being passively managed, tries to match the returns offered by the underlying index.

How to Invest in Index Funds in India - Stepwise Process

Do you have questions about investing in Index Funds and wondering how to buy index funds in India? If so, we've got you covered on this. This section discusses both online and offline ways to invest in Index Funds.

- Online Process

• STEP 1: Open a mutual fund account through any secure website of your choice.
• STEP 2: If you haven't already, finish your KYC procedures and move on to the next step.
• STEP 3: Put in the necessary information as needed.
• STEP 4: Depending on your financial objectives, choose the fund or funds you want to invest in.
• STEP 5: Choose the appropriate fund and transfer the required amount.
• BONUS STEP: You can also set up a standing instruction with your bank if you want to invest monthly via SIP (systematic investment plan).

- Offline Process

• STEP 1: Fill out the application form and the KYC form carefully and submit.
• STEP 2: Add in and enter the necessary information as needed.
• STEP 3: Based on your financial appetite, choose the fund or funds you want.
• STEP 4: Pay the investment amount using the chosen payment method of your convenience.
• STEP 5: If you want to invest via SIP each month, set up BillPay, eMandate, eNACH, ADF (Auto Debit Form), or OTM (One Time Mandate) digitally or offline.

Benefits of Investing in Index Funds

When it comes to Index Funds in India, there are numerous benefits of Index Funds that you need to know about.

Some of the advantages of investing in Index Funds in India are:

• Lower Expense Ratio and Low Fees

Index funds typically have lower expense ratios than actively managed mutual funds, which means that you can invest more of your money where it will do the best for your portfolio.

• Tax Benefits

Since Index Funds are passively managed, they don't buy and sell individual securities as frequently as actively managed mutual funds do. This reduces their tax liabilities and increases your after-tax returns over time.

• Easy to Manage

Index Funds are also easier to manage than actively managed mutual funds because they don't change their asset allocation easily.

This means that once you invest in an Index Fund, its asset allocation remains the same until the time when you decide to change it yourself or until another manager takes over from your current one.

• Impartial Investing

Index Funds invest using an automated, law-based process. The amount to be invested in index funds of different securities is specified in the fund manager's mandate. By doing this, human discretionary bias in investment decisions is eliminated.

Things Investors Should Consider Before Investing in Index Funds

Here are a few things an investor must consider while finding answers for how to invest in index funds in India-

1. Risks and Returns

Since index funds track a market index and are passively managed, they are less volatile than actively managed equity funds. Hence, the risks are lower. During a market rally, index funds India returns are usually good.

However, it is usually recommended to switch your investments to actively managed equity funds during a market slump. Ideally, you should have a healthy mix of index funds and actively managed funds in your equity portfolio.

Further, since the index funds endeavour to replicate the performance of the index, returns are similar to those of the index. However, one component that needs your attention is Tracking Errors. Therefore, before investing in an index fund, you must look for one with the lowest tracking error.

2. Expense Ratio

The Expense Ratio is a small percentage of the total assets of the fund charged by the fund house toward fund management services.

One of the biggest USPs of an index fund is its low expense ratio. Since the fund is passively managed, there is no need to create an investment strategy or research and find stocks for investing. This brings the fund management costs down, leading to a lower expense ratio.

3. Invest According to Your Investment Plan

Index funds are recommended to investors with an investment horizon of 7 years or more. It has been observed that these funds experience fluctuations in the short term, but they average out over the longer term.

With an investment window of at least seven years, you can expect to earn returns in the range of 10-12%. You can align your long-term investment goals with these investments and stay invested for as long as you can.

4. Tax

Being equity funds, index funds are subject to dividend distribution tax and capital gains tax subject to dividend distribution tax and capital gains tax.

5. Dividend Distribution Tax (DDT)

When a fund house pays dividends, a Dividend Distribution Tax (DDT) of 10% is deducted at the source before making the payment.

6. Capital Gains Tax

On redeeming the units of an index fund, you earn capital gains - which are taxable. The rate of capital gains tax depends on the holding period - the period for which you were invested in the fund.

• The capital gains earned by you for a holding period of up to one year = Short Term Capital Gain (STCG), which is taxed at 15%.
• The capital gains earned by you for a holding period of more than one year = Long Term Capital Gain (LTCG). LTCG up to Rs. 1 lakh is not taxable. Any LTCG above this amount is taxed at the rate of 10% without indexation benefits.

You may also want to read Best Index Funds to Invest in India

Conclusion

Index Funds have the capability to assist you in saving a lot of money and could set you up for success in the future.

Due to the recent reclassification of mutual fund schemes by SEBI (Securities and Exchange Board of India), many financial planners are convinced that index funds in India will eventually become significant players among the various investment options.

To put it mildly, the Indian stock market can be intimidating. Stock investing seems to be a difficult process because there are thousands of stocks, a wide range of financial instruments, and confusing jargon surrounding it.

Additionally, it is simple to be drawn into the volatile world of day trading, where you buy and sell stocks every day in an effort to make large profits by betting on swift price changes.

It might be the best option for you, though, if you are wary of taking chances and want to make long-term investments with modest returns and the advantages of Index Funds.

Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.

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Research Analyst - Bavadharini KS