Mutual Funds 101 – A Detailed Guide to Index Funds in India

Before we begin with mutual funds, let us clarify what does 101 have to do with mutual funds? 101 denotes introduction of anything to which it is attached. In simple terms Mutual funds 101 meaning introduction to mutual fund or mutual fund for beginners. Mutual Fund is not a rocket science to understand, any person even from a non-commerce background can easily acknowledge the same.

The basics of mutual fund are, money pooled or put together by different people and managed by an independent or non-related person on their behalf. This independent person then invests in different stocks or shares or debentures and many more such avenues, with one single objective to maximize profit and minimize losses.

How is the objective attained? Let us take an example if SBI mutual fund invest in pharmaceutical sector, as and when the pharmaceutical sector shares rise, SBI mutual fund will earn profit. Now how is this profit divided? Just like shares, as and when the company performs better, its share price rises and vice versa, on a similar note as when the investment of mutual fund rises, its NAV rises.

 New word alert ‘NAV’, NAV = Net asset value. Once the investors pools or invests their money in mutual fund they receive units of that mutual fund, just like share certificates. These units can be sold at any given day, at the net asset value per unit.

Let us assume you have invested 10,000 Rupees in mutual fund and received 500 units in return on 1^st June. Now if you wish to sell these units on today 14^th June, the amount you will receive is nothing but 500 x the NAV of 14^th June (assume 22) i.e. 500 x 22 =11,000. The per unit profit you earned in 14 days is Rs. 2 and total profit = 500 x 2 = 1000 Rs. This is how the mutual fund mechanism work. Now let us know what index funds are.

Index funds

The mechanism followed is same in relation to performance of index funds, however the main difference of index funds is its direct relationship to the index it is tracking.

Normally mutual funds are managed by independent professionals actively. In opposition to that fact, index funds are dependent entirely on the performance of the indices and not to outperform them. So how do index fund work?

Let us take an example where a mutual fund purchase stocks of nifty in the exact same proportion. Now the performance of this mutual fund will exactly match the performance of Nifty 50 without any interference of other factors. In exceptional cases there can be a mismatch in the return of mutual fund and returns of indices, this is called tracking error. The professionals will try to minimize this tracking error in order to match the returns of the index.

The basic advantage in index fund is that it is not dependent upon the professional’s judgement but on the index’s performance. An individual judgement is prone to error; however an index is much more reliable to that.

Characteristics of Index fund.   

1. Passive Funds: Index fund are not out performers, but their main target is to match the performance of its index. Since index fund performance is solely based on the index they follow, unlike active fund these funds are passive in nature.
2. Market dependency: Index fund are highly dependent on the performance of an index, and these index and nothing but market benchmarks like Nifty 50 or BSE 30.Therefore the performance of Nifty 50 or BSE 30 will speak up for the index fund’s performance.
3. Stable fund. Index fund being a fund dependent upon index is a safe bet. Since the performance of index is directly proportional to index fund, it absorbs all the volatility of equity market and reduces the risk factor. However, this factor affects the return perspective as, index fund are primarily from the low risk profile.

Who should invest in Index fund?

Any investment opinion depends upon the investment objective and risk-taking capacity. As far as index funds are concerned, one of their characteristics is a low risk fund, which makes it suitable for risk averse investors. Since index fund are passively managed funds, they may lack the extra-ordinary return of actively managed fund but looking in the long run they may outperform actively managed fund. Thus, investors looking for a long term perspective with objective attainment longer than 7-8 years may opt for this fund. Moreover, investors expecting quicker and higher return may have to look for other avenues.

Index fund –Things to consider.

1. The return aspect. Very important factor while choosing index fund, as index fund are primarily placed to match the performance of underlying indices. Therefore, while choosing index fund, it is very important to see how the performance of underlying indices is and what its future holds.  For example, if the BSE Sensex is falling and the future is also bleak for it, it is better to switch your investment but at the same time it is the best time to invest in index fund as you will receive higher units per investment.
2. Tracking error. It is nothing but the difference between performance of the fund and performance of the index. Lower the difference better the fund. Therefore, while choosing index fund it is advisable to locate fund with minimum tracking error, in order to maximize the performance.
3. Expense Ratio. A very important factor while investing in any mutual fund, as it directly affects your return. An expense ratio is the per unit cost of managing the fund. In simple terms it is what the professional who manages the fund charges you for managing your money. This ratio is higher in actively managed fund, however, is very low for index funds because of its passive nature. However, expense ratio of two different index fund might be different, hence targeting the fund with minimum expense ratio is important.
4. For the longer innings. Since index fund is heavily dependent on the indices, it barely matches the return of actively managed funds. However, since the indexes are powerful enough, in the long run they will not only match the active fund return in averaging but also outperform them. Hence investors choosing index fund must be ready to play the longer innings and stick with fund for least 7-8 years to earn considerable return.
5. Tax angle. Index fund is taxable under the head of capital gains. Therefore, any profit earned in index fund is charged at the rate 15% if liquidated before 1 year by short term capital gain. No tax on gain below 1 lakh although any profit earned post 1 year will be taxed at the rate 10% on over and above of 1 lakh rupees of profit.

Best index funds

1. HDFC Index Nifty 50
2. Aditya Birla Sun Life Index Fund Growth
3. UTI Nifty Index Fund Regular Plan Growth