Not every investor has the time, inclination or expertise to analyse individual companies. For such savers, passive investing offers an elegant alternative: buy a product that simply mirrors a market benchmark. Funds tracking the BSE Sensex have attracted steady attention from first-time investors who want broad exposure at low cost. The wider family of BSE Indices also supports products tailored to different segments of the market. This guide explains how index funds and exchange-traded funds work, what they cost, and how to decide whether they suit you.
What Passive Investing Really Means
An actively managed fund has analysts and fund managers who try to find stocks that will beat the market. A passive fund does not attempt to beat the market. It tracks a benchmark by buying the same companies, in the same weights, as the benchmark index. It will rise and fall nearly in step with the benchmark index.
The attraction is simplicity and low costs since there is no research team. The impact of these lower annual charges can be considerable over a long period.
Index Funds Versus Exchange-Traded Funds
Both types of funds track a benchmark, but they differ in their operation. An index fund is a mutual fund. You can invest in an index fund through a systematic investment plan with contributions as low as a few hundred rupees per month; the units are purchased or redeemed at the end of the day at a price based on the fund’s net asset value.
An exchange-traded fund is similar to a share; it is traded on the stock exchange. You need a demat account to do that; there will be market prices at which one can buy or sell the ETF during market hours. The prices may trade at a premium or discount to the value of the underlying index; this spread is kept narrow by market makers. The expense ratio is often lower for ETFs, but a demat account and the associated hassle can tilt the choice in favour of the index funds.
Understanding Costs and Tracking Error
The expense ratio shows the annual fee in percentage terms that one pays on the money invested in the fund; it is best to compare the expense ratios of funds that track the same index; lower is better, but not always. One also needs to look at other factors like the fund house’s track record and the size of the assets under management.
The tracking error shows how closely the fund mirrors the benchmark or the index. The lower the better; a good fund will track the index closely, only a little lower due to expenses and cash holdings. A high tracking error is an issue; look at a fund’s factsheet published every month and check out the tracking error. Understand the fund house’s track record and the size of the assets under management.
Fitting Index Products into Your Plan
Start by investing in passive funds as the core component of your portfolio. A salaried investor can invest a certain amount in a large-cap index fund every month, supplement it with a mid-cap index fund, and also invest some money in debt instruments to create a portfolio of large-cap, mid-cap, and debt. The allocation depends on factors like the investor’s age, financial goals, and risk appetite.
Be realistic about the rewards offered by an index fund. It is unlikely that large-cap funds will help you fight inflation. In a falling market, it will also fall in value; the advantage with index funds is that it will rise consistently with the market. The most important point is to stay invested and not stop the SIP during a down period since there is no way of knowing when the market will bottom. Consistent investing smoothens the fluctuations and helps with the power of compounding.
Tax Considerations
Taxes are calculated on the redemption proceeds of an equity-oriented fund. Short-term and long-term gains are taxed at different rates; tax laws change from time to time, so ensure you are aware of the latest rules or speak to a tax advisor before redeeming. It is best to hold index funds for the long term; it is also in line with the idea of investing in such funds.
A Simple Way to Begin
Decide on the goal and the time horizon, open the required accounts, choose a low-cost fund with a long-standing track record and make regular contributions. Do not look at your investments every day. Instead, review them once a year. For many families in India, this approach has offered a steady way to build wealth without getting caught up in the noise of the markets.
