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What are Low-cost Index Funds? How do they Work?

What are Low-cost Index Funds? How do they Work?

According to the Business Standard, about 46-48% of younger generations (millennials and Gen Z) prefer to invest in index funds. Low-cost investment funds are excellent investments for veteran and novice investors alike. They provide an inexpensive, low-risk way for people to build their portfolios instead of investing in individual stocks. Index funds can also offer attractive returns. In this article, we delve into what low-cost index funds mean, their definition, how they work, and what to consider before investing in one.

What are Index Funds?

Index funds track specific collections of assets, known as an index. They may include stocks, commodities like gold, bonds, or other assets. These funds are best for long-term investments. Some leading index funds in India include:

– Nifty Midcap 150 index fund

– Nifty 50 based index funds

– BSE Sensex based funds

– BSE Sensex Index Fund 

– Nifty based Index Fund

What are Low-Cost Index Funds?

Index funds with low expense ratios are known as low-cost index funds. They are cost-effective (and often low-risk) options for investors. They replicate a benchmark index’s holdings and invest in the same proportions. This means they can significantly reduce the need for in-depth research and active decision-making when investing, minimising costs.

How Do Low-Cost Index Funds Work?

Low-cost index funds do not actively invest in the market. They are passive investments, tracking assets included in the index. Index funds match the performance of their indexes by holding the same assets in the same proportion as the indexes.

EFTs, similar to stocks, are securities traded on stock exchanges. They track multiple assets like commodities, bonds, and indices. Like index funds, they are managed passively. Mutual funds, on the other hand, can utilize passive or active management strategies. Their investment ratios can vary and are usually categorised into different types, like hybrid funds, equity funds, or debt funds.

What are Some Factors to Consider When Investing in Low-Cost Index Funds?

Low-cost index funds can be helpful tools for people looking to improve their finances. Some factors to consider before investing in them include:

1. The Total Expense Ratio (TER)

TER refers to the total cost of operating and managing an index fund. A fund’s returns are directly affected by the total TER. Index funds with higher TERs may yield lower returns.

2. Tracking Error (TE)

Tracking errors refer to the difference between portfolios and the underlying index they follow. A higher TE for an index fund could indicate a bigger variance between its performance and the index fund it follows.

3. Long-term Returns

Before investing in an index fund, you must check the type of returns it can produce and whether they align with your financial goals. A fund’s past performance can be viewed over a period of time, and while this can provide some indication of how it might perform in the future, it however does not guarantee positive trends.

4. Taxation

Index fund taxation depends on the composition of the indexes they follow. Any gains from index fund investments are treated the same as capital gains. For example, index funds replicating equity indexes are taxed as equity-oriented funds. However, these regulations may differ for debt or commodity funds.

Summing Up

Index funds are generally less costly than actively managed funds and can provide exposure to several securities in one single fund. They are also accessible for newer investors to understand, making them good starting points for those wanting to begin their investment journeys.

If you want to begin your investment journey and reach your financial goals, consider Tata Capital Wealth, which offers expert guidance and customised financial plans.

To learn more, visit the Tata Capital Wealth website today!

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