Index Funds Sahi Hai

Nifty 50 Index Fund, Simple, Cost efficient, and Smart way of Investing 

Background

John C. Boggle, founder of the Vanguard Group, (father of Index Funds), in his epic book on investing “The Little Book of Common Sense Investing” explains the importance and meaning of Index Funds very beautifully with the help of many relevant examples and quotes of the ace investors from different times which inclined me to write this article.

In his words ‘The index fund is simply a basket (portfolio) that holds many, many eggs (stocks) designed to mimic the overall performance of any financial market or market sector.’ Classic index funds, by definition, basically represent the entire stock market basket, not just a few scattered eggs. Such funds eliminate the risk of individual stocks, the risk of market sectors, and the risk of manager selection, with only stock market risk remaining (which is quite large enough, thank you)”.

What is Nifty 50 and how it is computed?

Nifty 50 is the most common, liquid and tracked index by all the traders/investors of the share market to determine the direction wherein the broader market is moving ahead. It is the flagship index on the National Stock Exchange (NSE) which consists 50 largest conglomerates of India based on the free float market capitalization of companies listed on the NSE. It captures approximately 66% of NSE float-adjusted market capitalization and is a true reflection of the Indian stock market. It captures all major sectors of the Indian Economy, offering exposure to Indian Market in one efficient portfolio.

The NIFTY 50 is computed using a float-adjusted, market capitalization weighted methodology, wherein the level of the index reflects the total market value of all the stocks in the index relative to a particular base period.

The Free Float Market Capitalization is a method of calculating the market capitalization of a stock by taking the equity’s price and multiplying it by the number of shares readily available in the market for trading, it excludes locked-in shares, such as those held by insiders, promoters, and governments etc while computing the free float of market. 

Example:

XYZ Limited is having 100000 equity shares trading at a price of Rs. 100 per share.

Following is the detail of shareholders

1. Promoter holding 20000 shares

2. Government Holding 10000 Shares

3. Shares under lock in category/employee trust etc. 10000 shares

Free Float of Market Capitalization = (100000-20000-10000-10000)*100 =60,00,000/- 

Index Review frequency:

The review of NIFTY 50 is undertaken semi-annually based on data for six months ending January and July. The replacement of stocks in NIFTY 50 (if any) is generally implemented from the first working day after F&O expiry of March and September. In case of any replacement in the index, a four weeks’ prior notice is given to the market participants. Additional index reconstitution may be undertaken in case any of the index constituents undergoes a scheme of arrangement for corporate events such as merger, spin-off, compulsory delisting or suspension etc. The equity shareholders’ approval to a scheme of arrangement is considered as a trigger to initiate the exclusion of such stock from the index through additional index reconstitution. 

Taxation of Nifty 50 Index Funds:

The Nifty 50 Index Funds fall under the category of Equity Mutual Funds in accordance with the SEBI guidelines on classification of mutual funds issued vide circular no. SEBI/HO/IMD/DF3/CIR/P/2017/114 dated 6^th October, 2017.

https://taxguru.in/sebi/categorization-rationalization-mutual-fund-schemes.html

As per the Income Tax Act, 1961, Equity Mutual Fund units when purchased under the growth plan fall under the definition of Capital Assets as defined under Section 2(14) of the Income Tax Act, 1961, if are held as investments, hence, the capital gain provisions get applied for the taxability of mutual funds units. Section 45, the governing provision of the capital gain states that capital gain on transfer of capital assets shall be taxable in the year in which such capital asset is being transferred.

In accordance with Section 2 (42A) of the Income Tax Act, 1961, equity mutual funds units are classified as long term capital assets, if, these are held for more than 12 months and short term capital assets, if, transferred within 12 months of purchase of units. The Long Term Capital gains on transfer of equity mutual fund units in excess of Rs. 1,00,000 for the year are being taxed @10%, while the Short Term Capital gain on transfer of such units are taxed @15%. 

Advantages of investing in the Nifty 50 Index Funds

1. Low Expense Ratio: Index funds are not actively managed, having lower turnover, resulting lower expenses charged by the AMCs for management of such funds. AMCs charge total expenses for the management of such funds as low as up to .10% of amount invested while those expenses ratio for an actively managed large cap funds are in the range of 1.5% to 2%, which itself makes, Index Funds, a better investment candidate for the retail investors seeking to create the long term wealth. Comparison of Expense ratio of Nifty 50 Index Funds with Large Cap Funds of few AMCs is given hereinbelow:  

(Source Data Fact Sheets of AMCs for the month of July)

2. Diversification: Diversification is one of the most important aspect of the investing, which has been advocated by the great investors of all time including Mr. Benjamin Graham, the father of value investing. As an investor, if, we don’t diversify our portfolio adequately, then, on a rainy day we might end up losing 80-90% of our wealth, and once it is gone, it is next to impossible to regain the same. For example an investor lost it’s 90% of wealth in a single stock, the stock has to rally 900%, thereafter only the investor would come back to zero. Investment in Nifty 50 Index Funds, provide a well-diversified portfolio of the top 50 conglomerates of India engaged in the different sectors to the investor.

My personal favorite quote on diversification is of Jeff Yass which explains the importance of diversification very beautifully and relevantly “If you invest and don’t diversify, you’re literally throwing out money. People don’t realize that diversification is beneficial even if it reduces your return. Why? Because it reduces your risk even more. Therefore, if you diversify and then use margin to increase your leverage to a risk level equivalent to that of a non-diversified position, your return will probably be greater”.

3. Steady Return: Many investors are afraid of owning the Equity Class, considering it as the most risky class, they think so because either they have inadequate knowledge of the asset class or they just jump the gun to direct equity and derivatives trading and burn their hands by losing entire money, never returning to Equity class. Owning Equity class by investing in Index Funds is the simplest and smartest way of investing which assures you return and appreciation of wealth over the period. Summary of the return of Nifty 50, over the period is as under:

Above return clearly indicates, the longer you stay in the market, the higher return you draw from the market. Above returns are exclusive of  an average of 1-1.5% Dividend yield which if reinvested, will further enhance the return of nifty at least by 2%.

4. Exit Load: Exit load is a type of penalty levied by the Assets Management companies on the investors for early redemption of funds. Most of the AMCs impose a penalty of 1% of the amount of investments on actively managed funds, if, withdrawn within one year of the investments while in the case of Index Funds lock-in time period is generally between 3-7 days of investments which clearly give an edge to Index Funds over the actively managed funds.

Till now, we have understood investing in Nifty 50 Index fund is very simple, cost efficient and smart way of investing, still only a few investors invest in Index funds and AUM size of Index Funds are much lower than the AUM size of the large cap funds of the same AMC. Let us try to understand the reasons thereof now:

5. Very low Commission to the distributor: In India, people do most of the investing based on the advice rendered to them by their bankers or their mutual funds agents, who are carrying the business of selling mutual funds units and earn commission by selling these units. Their business flourishes when the amount of commission rises, higher percentage of commission raises the amount of commission, and makes their business better. Bankers/Mutual Fund Agents always keep the percentage of commission which they are going to get from any fund in the back of their mind while advising any investment to the investors.

A comparison of commission (based on July month fact sheets of AMCs) a distributor gets for advising an Index Fund and a large cap fund is herein below: 

The above table depicts that distributors selling the mutual funds are having very less incentive for selling the index funds as compared to selling the large cap funds, hence, are not recommended to clients by them resulting in lessor amount of investments as compared to actively managed funds and smaller size of AUM in the schemes.

6. Fund Manager Ability to beat the Market: Whenever any investor is going to ask to their bankers or their mutual funds advisor, shall I invest in Index Fund, their reply would be no, (reason we know by now), why do you want to invest in Index Funds while we can actually beat the index by 3% or more and here is the historic return you can look for the same (Although mutual fund schemes itself states that past returns are not guaranteed returns), but they do present the same past data to you and convince you to not to buy the Index Funds.

One of the biggest reason why actively managed funds have beaten the index funds in the past is weightage of public sector undertakings, Public sector undertakings which have been wealth destroyer of many investors shall be discussed in detail at later stage, underperformance by those entities since their listings is one of the key reasons of underperformance by Nifty 50 Index when compared to actively managed funds in the past. Whether, it may continue to occur in the future also is a million dollar question to be answered by the upcoming future only as these PSUs have already lost so much that some of these are trading at a valuation of less than 5 PE. 

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Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. All Content in the article is the information of a general nature and does not address the circumstances of any particular individual or entity. Please discuss this with your financial advisor before making any investment decisions.