Over the years, I learned a great deal about money management by watching my parents navigate the tricky bylanes of household finance. I learned to steer clear of bad debts. I learned to save first and spend later. But unwittingly, I also inherited a significant aversion to market risks. So, up until I was the ripe old age of 25 (for the markets, I’ve heard that 25 is old), I only invested in fixed deposits, gold and government schemes to achieve my financial goals.
In other words, I had grown into my parents.
But everyone around me was practically obsessed with investing in stocks. And eventually, a combination of curiosity and FOMO drew me to the party. Afraid of jumping right in, I looked for the best of both worlds - good returns, but also not too much risk. My search for this perfect product led me to index funds.
Let me answer this with another question. What is an index?
A stock market index is simply a group of stocks. It acts as a benchmark - either for the whole stock market or for a segment of it. The Nifty 50 is one index. It is made of the top 50 stocks trading on the NSE. And the BSE Sensex is another. It includes the 30 largest stocks on the BSE. There are also indices for different market sectors.
These indices helped me understand how the market was moving overall. Plus, they were also made of the best stocks on the exchange. The crème de la crème. And that certainly drew me in.
But there was a catch - I couldn’t invest in an index as such. Because it’s just a benchmark - a statistical tool. But I could invest in index funds. (And I did!)
Index funds are just mutual funds that track an index. They invest in the stocks which make up the benchmark that the index fund tracks. Read that again...slowly.
So, a Nifty Fund will invest in the top 50 stocks on the NSE. And a Sensex Fund will invest in the best 30 BSE stocks. You get the idea.
When I first let my risk-loving friends in on my new secret, they were equally pleased and disappointed. Pleased, because I had finally seen what the markets had to offer. Disappointed, because I chose index funds instead of traditional, managed funds.
But I had my reasons.
The number one trivia on my bio is ‘low risk taker.’ So, I naturally gravitated towards index funds, which carry lower risks than actively managed funds. Plus, index funds are also inherently quite diversified across sectors. That pulls the risk down even further.
In an actively managed fund, a lot depends on the skill of the fund manager. Their experience and their inherent biases will no doubt affect the portfolio, at least a wee bit. But index funds have none of that trouble. They simply track the chosen benchmark.
I’m great at research, but I’m a market newbie. So, I would have to study a lot of things before picking an actively managed fund. Like past returns, the total AUM (Assets Under Management), the fund manager’s history and more! Index funds are easier to understand and simpler for beginners.
Now, this is a big one. The expense ratio shows you how much of a fund’s assets are used to manage and operate it.
Fund managers need to constantly perform their own research and track the markets in active funds. And they need to be rightly compensated for this. So, the cost of managing a fund actively is much higher than operating a passive index fund. This is why the expense ratio on index funds is lower - and easier on the wallet.
Once I’d figured out that index funds were it for me, I must admit I felt like a kid at a candy store. There are SO many mutual fund houses in the Indian financial markets. And all the top fund companies have their own index funds.
It was overwhelming at first, but I eventually came up with a simple, 4-step process.
Step 1: Pick an index
Pick an index to invest in. You may be tempted to choose an exotic index. But it’s best to select an index that you understand.
Step 2: Shortlist fund houses
Compare fund houses and choose the ones with the best customer service and track record. A good fund but a poor fund company is not a fun combination. Trust me.
Step 3: Check the expense ratio
This is vital. Some fund companies may have a higher expense ratio on their index funds. Unless you can justify this with top-notch service or something, I’d say it’s better to keep your expenses on the lower side.
Step 4: Check the tracking error
The performance of index funds tend to differ slightly from the indices they track. This can be due to fund expenses and delays in buying or selling the stocks in the fund. The tracking error shows you how much the difference is, and the lower the tracking error, the better the index fund is.
Like the idea of index funds but don’t know where to begin? Well, it’s always a good investment strategy to begin at the top. Check out the top index funds in India, ranked by their performance over the last 5 years.
There are no free lunches - and certainly no free profits. You can credit my CA for this witty repartee, but it’s true. Index fund profits are taxed as capital gains. And the rate of tax on index funds depends on how long you hold the funds.
I sold my index fund investments in less than a year, so I had to pay tax on my short term capital gains. At 15%.
But if you choose to hold your investments for longer than a year, you need to pay tax on your long term capital gains at 10%. But there’s some good news here. Long term gains up to Rs. 1 lakh are tax-free. If you’re otherwise in the 30% tax bracket, this is sure to be welcome news!
Well, it’s time to wrap up my memoir of taking the leap and investing in the markets - even if I took the safe route to it. If you relate to any part of my journey, index funds are something you should consider too. For the risk-averse, it can bring the possibility of better returns at low-risk levels. And for the risk-takers, it can bring some level of stability in an otherwise volatile portfolio.
Either way, it’s a win-win!
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