With the growing discussion about index funds and little awareness about the subject, it is extremely important to know how to choose the right index fund. Index funds are a passive investment option in the market. A few of the popular indexes include HDFC Nifty 50 Index Fund and SBI ETF Sensex in India and Vanguard S&P 500 ETF and Vanguard FTSE All-World ex- US ETF internationally.
While considering how to choose an index fund, your focus should be less on the big and famous names and more on your investment goals, the impact of expense ratio on your returns, AUM, the reputation of the fund manager, and many others, which will be discussed below.
How to choose an index fund:
Define investment goals:
Investment goals can be classified into a few key areas whether for yourself or your family. Keeping this in mind lets sort them into a few categories.
- Retirement goals
- Education (own or children)
- Wealth
- Accumulation
- Others (e.g., marriage, buying a house, starting a business etc)
Your goal should have a time horizon, as index funds are generally best for long-term investing. Matching your investment timeframe with your goals help you benefit from steady growth and compounding. For higher returns, consider growth index funds. They focus on companies with significant long-term growth potential.
For instance, investing ₹10,000 monthly for the next 30 years can secure retirement while ₹5,000 monthly for 10 years can cover education, and ₹8,000 monthly for 5 years can help buy a house, each of these goals can be fulfilled with steady increase and compounding.
Assessment of Risk Tolerance:
Risk tolerance reflects the level of risk you're willing to take while investing. Factors that influence it include age, income, financial situation, and the timeline for achieving your goals.
For example, younger investors have more time to recover from bad decisions, giving them a higher risk threshold. Meanwhile, an older person's income and financial situation may allow them to invest larger amounts, seeking more profit in the long run.
Various tools, such as online questionnaires and risk assessment calculators provided by financial institutions, are available to assess your risk tolerance. These tools evaluate factors like your investment horizon, financial situation, and response to market fluctuations. Using them can help you understand your risks and make informed decisions.
A few examples of such tools include:
- Vanguard Risk Tolerance Questionnaire
- FINRA Investor Risk Profile Quiz
- HDFC Risk Profiler
- Index funds sahi hai risk calculator
Considering the top index funds in India will help you match your risk profile.
Consider expense ratio:
Index fund expense ratio is the annual fee that the fund charges the investors to cover its operating expenses.
It is now established that index funds are cost-efficient, and the role of the fund manager is limited, which reduces the management fee and expense ratio.
The reduction in expense ratio also ensures that they are comparatively cheaper than actively managed funds. Observing the expense ratio is important because it affects the net returns.
Example:
| Fund type | Fund name | Expense ratio | Net returns (1year) |
| Index fund | HDFC index fund - Nifty 50 plan | 0.3% | 27.18% |
| Index fund | ICICI Prudential Nifty next 50 Index fund | 0.4% | 27.17% |
| Actively managed fund | Axis blue chip fund | 0.62% | 29.52% |
Check tracking difference:
The difference between the return of index funds and that of its index is called tracking difference.
Example: When the Nifty 50 index goes up by 1% and the Nifty 50 index fund goes up by 0.90%, this difference of 0.10% is called tracking difference.
While checking the tracking difference, it is useful to compare it with the best small-cap index fund to understand how they track their respective indexes.
So, the bottom line here is that one has to choose a fund with the least tracking difference.
Check AUM (Assets under management)
AUM (Assets Under Management) gives information about total money present in the fund, it explains how big or small the fund is.
Here's why AUM is important:
- Size and Liquidity: A larger AUM indicates better liquidity, meaning you can buy or sell units of the fund more easily.
- Fund Stability: Higher AUM often reflects investor confidence and can contribute to the fund's stability.
- Operational Efficiency: Bigger funds benefit from economies of scale, potentially reducing operational costs.
A higher AUM suggests that the fund is more established and can provide better liquidity and stability. Index funds with highest returns have a higher AUM.
Evaluation of fund manager and provider reputation:
Evaluation of past returns, expense ratio, tracking difference, and AUM is extremely important. Still, the most neglected aspect of choosing an index fund is evaluating the reputation of the fund manager or provider. A skilled manager can enhance returns and reduce risks.
When assessing a fund manager's reputation, the Best Nifty 50 Index Fund can serve as a benchmark for evaluating effective fund management.
Assess a fund manager based on the following:
- Aggressive vs. Conservative: Their approach to risk and return.
- Value vs. Growth: Their stock selection strategy.
- Credit Risk Style: Quality of bonds in debt funds.
- Adherence to Mandate: Compliance with the fund's investment rules.
- Investment Time Horizon: Whether they trade frequently or hold long-term.
- History of Managing Funds: Past performance and effectiveness.
- Number of Schemes Managed: The number of funds they oversee.
If a fund manager leaves, monitor the fund's performance for a few quarters and consider potential capital gains taxes before deciding to sell.
Understand tax implications:
Understanding tax implications thoroughly is crucial for achieving success in investing. Taxes are levied on both dividends and capital gains.
Dividends: Dividends are taxed similarly to income tax, with the rate of taxation being the same as that of your income.
Capital Gains:
- Short-term Capital Gains: If the holding period before you sell the fund is 12 months or less, 12.5% of the capital gain is taken as tax.
- Long-term Capital Gains: Holding the investment for more than 12 months brings the tax levied down to 20%
An important point is that tax is levied only if the invested amount is Rs. 1 Lakh or more; no tax is imposed on investments less than Rs. 1 Lakh.
Understanding how dividends and capital gains are taxed and the thresholds for these taxes can help you better plan strategies to maximize returns and minimize tax liabilities.
Make a decision and monitor regularly:
Keeping an eye on the fund is essential once you understand all the relevant information and decide which index to choose.
Even though it is a passive investment, you need to have a look at least once a quarter to:
- Evaluate the fund performance.
- Check for significant changes in the fund's strategy, management, or expense ratio.
Based on your ongoing assessment, be prepared to adjust your portfolio. This might include:
- Rebalancing your investments.
- Switching funds if the current fund no longer meets your criteria.
Conclusion:
Investing is relatively easy if approached with a long-term plan. Understanding how to choose an index fund depends on understanding your goals, risk tolerance, expense ratios, and evaluating fund performance. Regularly monitoring your chosen fund and understanding the tax implications ensures wealth in the long term, and choosing from the best-performing index fund ensures you make a well-informed investment decision.
To make the best decision for your future, seek guidance from an index fund expert.
FAQ's
- What are the best index funds in India?
In India, there are numerous Index funds, but a few of the best index funds are:
- HDFC nifty 50 index fund: Known for tracking the nifty 50 with low expense ratio
- SBI ETF Sensex: This fund is highly liquid and offers exposure to Sensex
- Nippon India Index Fund—Nifty 50 Plan: This fund provides a cost-effective way to invest in the Nifty 50 Index.
- What are index funds for beginners?
For beginners, index funds aim to mimic the performance of specific indexes like the Nifty 50 or Sensex. They offer a simple and cost-effective way to invest in a diversified portfolio, making them ideal for those new to investing
- How can you invest in index fund options?
To invest in index fund options:
- Research and Select: Thoroughly go through all your options and choose the funds that match your requirement.
- Account opening: Open an account with a brokerage or mutual fund provider that offers index funds.
- Allocate Funds: Decide on the amount you want to invest and purchase shares of the chosen index fund.
- Monitor: Regularly review your investment and make sure it aligns with your goals.
- How do you select an index fund?
First, define your investment goals and assess your risk tolerance to select an index fund. Compare expense ratios to ensure low costs and check tracking differences to ensure accuracy in index tracking. Review the fund's AUM for stability and liquidity and evaluate the fund manager's reputation.
