Starting investing can be exciting as well as scary. For a new investor, choosing where to invest is the toughest part but is also a key for wealth generation. It takes time for a new investor to understand the nuances of stock market trading. So it may be best for a new investor to choose something with less risk as well as great returns. Index funds is one such option.

An index fund is a type of mutual fund which is very common amongst new investors. It is basically a fund that replicates a major index like Sensex and Nifty in India. All the stocks in the index are a part of the fund with the same weights as in the index. The portfolio of an index fund is identical to the index. Mostly, index funds are considered stable investments and they garner robust returns in the long term.

For example, a Nifty50 index fund that tracks the Nifty index will have the same 50 stocks as Nifty in the same proportions.

Like the portfolio, index funds also try to replicate the performance of the index. So if the Nifty has risen 20 percent in a year, the index fund will try to match the same. It does not try to outperform the markets like active funds but intends to generate returns in line with the market performance. They generally deliver returns a bit less in line with the index.

Who should invest

Index funds are generally preferred by investors with a low-risk appetite who expect predictable returns. These funds generally give returns matching the particular index it follows. Also, you do not have to keep tracking the fund. If there is any change in the index, the fund incorporates the same.

Also, it is better suited for long-term investors with a time horizon of 7-10 years at least. This gives time for the fund to recover in case of market crashes. While the risk is less than active funds, it still carries some risk in regard to market volatility.

Taxation of Index Funds

Since index funds basically trade in stocks, they are taxed as any equity mutual funds under long-term capital gains (LTCG) tax and short-term capital gains (STCG) tax. This depends on the duration for which you hold your funds. If you redeem your mutual fund units after holding them for over a year, you will be taxed under LTCG. This incurs a tax rate of 10 percent if your total gains are over ₹1 lakh. If the return is less than ₹1 lakh, it is tax-free.

However, if you sell your MF units before holding them for 1 year then STCG applies. Those units will be taxed at a flat rate of 15 percent, irrespective of the amount of return. It is the same for returns of over ₹1 lakh or less than that.

Dividends of index funds are also taxed. They are added to your taxable income and are taxed as per your income tax slab rate.

Now, let's look at the advantages and disadvantages of index funds.

Advantages:

Low expense: The low expense ratio is its main upside. Since the funds are not actively managed, hence, the investment manager does not have to formulate a strategy thus making your expenses low. Market regulator Sebi has capped the total expense ratio of an index fund at 1 percent, which is cheaper than any of the actively managed funds.

Good returns: Since these funds do not time the market or change depending on the market trends, they provide consistent returns to investors in the long term. These funds do not take excessive risks to outperform the markets but generate returns in line with the index. it is likely to reflect the growth of the index. For example, the 5-year CAGR of Nifty is around 15 percent. So the funds are more likely to give you similar returns. They are also less volatile as compared to active funds and are a safer choice.

Minimum investment: An investor can start a SIP in index funds for as low as ₹500 per month. Some active funds have significantly higher minimum investment criteria. You can invest through both lump sum as well as SIP mode in an index fund.

Diversification: Since index funds replicate the portfolio of an index, it invests in stocks from all sectors. So in case stock from one sector is underperforming, your losses will be capped by stocks of other sectors which are outperforming. So the value of one's investment is not adversely impacted.

Drawbacks

Flexibility: This is one of the biggest drawbacks of index funds. The fund manager cannot make changes in the portfolio even in case of major developments. The portfolio and weights of the stocks are fixed as per the index it is tracking. Even in case of a crash, the fund manager cannot add stocks that are less impacted or sell stocks that are pulling down the index.

Tracking error: This is another disadvantage of an index fund. It is the difference in returns between the index and the fund. While a fund manager tries to replicate the index as closely as possible, there is still some room for error. While selecting an index fund, one must choose the fund with the least tracking error.

No room to outperform: Index funds never outperform the market like active funds. Though they give stable and predictable returns, there has never been an index fund that has performed better than the index it is tracking.

With low risk, low costs and consistent returns, Index funds have become a popular choice for new as well as experienced investors. Even though there are some drawbacks, index funds are one of the safest equity investment instruments available to investors.