Index funds with low expense ratios,
or annual management costs, are a type of pooled investment. Since money lost
to fees is money that is no longer compounding on itself in your investment
account, investors who concentrate on limiting their investing costs can
produce much greater returns over time.
Since they have lower cost ratios and
are tax-efficient, index funds, a form of an exchange-traded fund (ETF), is
preferred by many investors over mutual funds. Because they are passively
managed, index-tracking ETFs often have low expense ratios. This lowers
operating costs. Active trading and internal stock analysis are not necessary
for passive investing strategies.
The two methods for investing in
equities are actively investing and passive investing. With passive investing,
one copies the benchmark index exactly, while with active investing, one
carefully selects stocks for their portfolio. Passive investors eliminate
unsystematic risk by mimicking the weights of the index's components. The fund
managers are not permitted to invest outside the index's listed companies or
deviate from the index weights. Investors may invest in benchmark indices
through a low-cost index fund, which makes it simple for them to match their
portfolio's exposure.
The weighting of index constituents
in a fund is the same as in the benchmark index itself. The index fund
replicates the changes in the index and tracks them in the fund portfolio.
Since the index fund mirrors the benchmark index, investors may generate
similar returns by investing in index funds. Indices such as BSE S&P Sensex,
NSE Nifty 50, and Nifty Midcap100 are tracked by index funds. Since index funds
maintain a passive investment strategy, their management fees are lower than
active funds. A lower-cost investment alternative is provided to investors seeking
a broader exposure to benchmark indices.
Returns from low-cost index funds
Low-cost index funds typically have
zero alpha, as there is no diversification within the investment portfolio
beyond the index's structure. Because the construction of benchmark indices is
based on time-tested strategies, investors may prefer to emulate the benchmark
returns rather than seek to outperform them. For example, an index fund
tracking the S&P BSE Sensex might generate the same returns as it did in
the previous year, provided that it accurately tracks it.
Taxation of Index Funds
Index funds that replicate benchmark
indices are taxed according to their composition. Index funds replicating
equity indices are taxed as equity-oriented funds. Index fund gains on
investments held for less than 12 months are taxed at a special 15% tax rate
(in addition to the normal tax rate and surcharges). If the investment has been
held for at least 12 months, the investors must pay tax at 10% (plus surcharges
and Cess) after availing an exemption worth Rs. 1 lakh towards LTCG on equity
shares and equity funds collectively. Low-cost index funds are an attractive
investment option for investors seeking exposure to benchmark indices as
opposed to relying on fund managers' stock selections.
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