The path to building wealth demands dedication and discipline. The market offers a variety of investment tools to help achieve financial goals. When it comes to long-term goals, some tools have proven to be better than others. Index funds stand out as an instrument with low-risk options for long-term goals such as retirement planning. In this piece, we explore index funds and their role in wealth creation.
Index funds are a type of mutual fund designed to replicate the composition of stock indices. Unlike actively managed funds where the fund manager makes individual stock selections, index funds are passive. The fund manager’s goal is to mimic the portfolio of the underlying benchmark index.
For example, if you invest in an index fund tracking the Nifty50 index, the fund manager allocates investments across the same 50 stocks featured in the index, following their proportional representation accurately. As a result, the performance of the index fund closely follows the movements of the index. Whether the index rises or falls, the fund’s performance reflects these changes in an equal manner.
Index Fund Returns
Returns are the most important aspect of any investment, and equity index funds have provided reliable returns over the decades. This is because the indices have multiplied investor wealth manifold. Historically, they have outperformed many actively managed funds as well. Some of the prominent index funds have given an average annual return of around 12-14% over the last two decades.
Costs of Investing
When it comes to investing in mutual funds, it is important to keep costs in mind. The expense ratio is the fee for managing your investment funds. For index funds, this fee is low compared to other types of funds that have someone actively making decisions about where to invest. It is lower because with index funds, there is not much need for constant decision-making. So, they are often called “low-cost funds.”
To give you an idea, some index funds have fees as low as 0.3 per cent to 0.30 per cent. On the other hand, if you go for actively managed funds, they can charge you more, usually somewhere between one per cent to 2.80 per cent of what you have invested. In simple terms, index funds are great because they keep these costs low, making them a smart choice for many investors.
Investment Amount
Whether you are an investor embarking on your investment journey or a pro-investor, index funds welcome all with open arms. You can start with as little as Rs 500.
Taxation
Taxation plays a crucial role in evaluating any investment. When it comes to index funds, they are treated in the same way as equity funds. Profits generated from index funds are categorised into long-term and short-term capital gains. If the fund is held for up to 12 months, the gains fall into the short-term category and are subject to a 15 per cent tax rate.
On the other hand, gains from funds held for over 12 months are considered long-term and taxed at 10 per cent. Notably, long-term capital gains of up to Rs one lakh annually are exempt from taxation. Additionally, any dividends received are added to your income and taxed according to the applicable slab.
Who Should Invest in Index Funds?
Index funds are a good choice for people who are new to investing or prefer lower-risk options. They provide exposure to the stock market without too much risk. If you are okay with the returns that the overall market gives, then index funds are a good fit. It is wise to keep your money in index funds for at least 5-7 years to get the most benefits because the market typically goes through cycles that last 6-8 years.
If you want higher returns, then you may diversify and invest in actively managed funds. Do note they cost more but are managed by fund managers who actively pick and choose investments, aiming to outperform the market indices.
Index funds help your investment grow proportionally by betting on the market’s overall growth trajectory. You do not need to stress over market timing. Moreover, it’s always good to have a diversified portfolio as per your financial situation.
FAQs
Index funds are a type of mutual fund designed to replicate the composition of stock indices. These funds are a good choice for people who are new to investing or prefer lower-risk options. They provide exposure to the stock market without too much risk. The path to building wealth demands dedication and discipline.
How do index funds build wealth? ›
Index funds invest in the same assets using the same weights as the target index, typically stocks or bonds. If you're interested in the stocks of an economic sector or the whole market, you can find indexes that aim to gain returns that closely match the benchmark index you want to track.
Are index funds good for beginners? ›
Index funds are popular with investors because they promise ownership of a wide variety of stocks, greater diversification and lower risk – usually all at a low cost. That's why many investors, especially beginners, find index funds to be superior investments to individual stocks.
Are index funds good for wealth creation? ›
It doesn't matter how the individual stocks perform, the overall stock market gains value over time. As a result, index funds generally provide high returns at a low cost, making them an excellent value for any investor. Index funds, in general, are appropriate for investors with a long time horizon.
Are index funds a good way to make money? ›
Index funds are a great investment for building wealth over the long-term. That's one reason they're popular with retirement investors.
Can you retire a millionaire with index funds? ›
Broadly diversified index funds can be your investment vehicle for a ride to becoming a millionaire retiree, if the stock market performs as it has in the past. If you know little about investing and have no desire to learn more, you still can be a successful investor. That's because you have the power of index funds.
Do rich people invest in index funds? ›
“When you're ultra wealthy you do have access to some unique investment opportunities, but the vast majority of ultra wealthy people's portfolios consist of index funds, ETFs, and mutual funds, and maybe some sector funds,” she says.
Which index is best for beginners? ›
ICICI Prudential Sensex Index Fund. Nippon India Index Fund - Sensex Plan. HDFC Index Fund - Sensex Plan. DSP Equal Nifty 50 Fund.
How many index funds should I own? ›
A commonly cited rule of thumb is to own between 10 and 20 mutual funds, but the actual number will vary depending on your individual circ*mstances. Too many funds can lead to unnecessary over-diversification and overlap. There's really no point in owning, say, two index funds that invest in the same index.
Should I just stick to index funds? ›
If you want to prove your mettle as a superior investor, index funds won't give you that chance. Short-term downside risk: Index funds track their markets in good times and bad. They can be volatile places to put your money.
Index funds are investment funds that follow a benchmark index, such as the S&P 500 or the Nasdaq 100. When you put money in an index fund, that cash is then used to invest in all the companies that make up the particular index, which gives you a more diverse portfolio than if you were buying individual stocks.
Can you withdraw money from an index fund? ›
If you sell an index fund in an IRA it is not a taxable event, and you can withdraw your contributions without penalty, the penalty only applies . Investments in open-end schemes are redeemable at any time. Withdrawing your mutual funds without investing them for long is not advisable.
Which index fund pays the most? ›
The Invesco S&P 500 High Dividend Low Volatility ETF has a 4.74% dividend yield, the highest among our recommendations, but its risk is average. Meanwhile, the iShares Core High Dividend ETF has a 4.09% dividend yield but an expense ratio of only 0.08%, much lower than the 0.3% ratio for the Invesco fund.
Is there a downside to index funds? ›
Disadvantages of index funds. While index funds do have benefits, they also have drawbacks to understand before investing. An index fund tends to include both high- and low-performing stocks and bonds in the index it's tracking. Any returns you earn would be an average of them all.
Can you retire a millionaire with ETFs alone? ›
Investing in the stock market is one of the most effective ways to generate long-term wealth, and you don't need to be an experienced investor to make a lot of money. In fact, it's possible to retire a millionaire with next to no effort through exchange-traded funds (ETFs).
What are 3 advantages to index fund investing? ›
Over the long term, index funds have generally outperformed other types of mutual funds. Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they're highly diversified).
