Your Questions Answered: I want to invest in Nifty 500 tracking mutual funds. Please elaborate on pros and cons | Mint

Q. My wife and I have invested in Sensex tracking index funds for the past 8 years and now we want to invest in other index funds. Can you please elaborate on the pros and cons of investing in mutual funds tracking the Nifty 500?

Arvind Alhuwalia, Chandigarh, Punjab

Understanding Nifty 500 index funds

Nifty 500 tracking mutual funds are designed to replicate the performance of the Nifty 500 index. The Nifty 500 index represents the top 500 companies listed on the National Stock Exchange (NSE) of India, covering a wide range of sectors and industries. These mutual funds aim to provide investors with diversified exposure to the Indian stock market by investing in the same companies and the same proportions as the Nifty 500 index.

Key features of Nifty 500 index funds

Diversification: Nifty 500 index funds offer broad market exposure by investing in a large number of companies across various sectors. This diversification helps reduce the risk associated with investing in individual stocks.

Low cost: These funds typically have lower expense ratios compared to actively managed funds. Since they aim to replicate the index, there is less need for active management, resulting in lower costs for investors.

Transparency: The portfolio composition of Nifty 500 tracking mutual funds is transparent, as they closely follow the Nifty 500 index. Investors can easily track the performance and holdings of the fund.

Performance: The performance of these funds closely mirrors the performance of the Nifty 500 index. While there may be slight deviations due to tracking errors, the overall returns are expected to be similar to the index.

Constituents of Nifty 500

As mentioned above Nifty 500 index covers a wide spectrum of industries and provides a holistic view of the Indian stock market. To be included in the Nifty 500 index, companies must meet specific eligibility criteria. Let’s delve into these criteria in detail:

Market capitalisation: One of the primary criteria for inclusion in the Nifty 500 index is market capitalisation. Companies are ranked based on their full market capitalisation, and the top 500 companies are selected. Market capitalisation is calculated by multiplying the current share price by the total number of outstanding shares. This criterion ensures that the index represents the most significant and influential companies in the market.

Trading frequency: To be eligible for inclusion, a company’s stock must have been traded for at least 90% of the trading days in the last six months. This criterion ensures that the stocks included in the index are actively traded and have sufficient liquidity.

Listing on NSE: Only companies listed on the NSE are considered for inclusion in the Nifty 500 index. This criterion ensures that the index accurately reflects the performance of companies listed on India’s premier stock exchange.

Turnover and market cap ranking: Companies must be ranked within the top 800 based on their daily turnover and market capitalisation. This ranking is crucial as it ensures that only the most significant and actively traded companies are included in the index.

Automatic inclusion for top 350 companies: Stocks that are ranked in the top 350 based on their full market capitalisation are automatically considered for inclusion in the Nifty 500 index. This criterion ensures that the largest companies by market cap are always part of the index.

Differences between Sensex and Nifty 500

The Sensex, also known as the S&P BSE Sensex, is one of the oldest and most widely followed indices in India. It consists of 30 large-cap companies listed on the Bombay Stock Exchange (BSE). The Sensex is also calculated using the free-float market capitalisation method. On the other hand, as mentioned above the Nifty 500 is a broad-based index that represents the top 500 companies listed on NSE. We have mentioned the key differences between the two below:

Number of constituents

• Nifty 500: This index includes 500 companies, providing a broad representation of the Indian equity market.
• Sensex: This index includes only 30 companies, focusing on the largest and most established firms.

Market coverage

• Nifty 500: Represents about 92% of the total market capitalisation of the National Stock Exchange (NSE), as of September 30, 2024. This means it covers almost the entire market, including large-cap, mid-cap, and small-cap companies.
• Sensex: Sensex focuses primarily on large-cap companies. In comparison to the Nifty 500 it represents a smaller percentage of the market cap of the companies listed on BSE.

Sector diversification

• Nifty 500: Due to its large number of constituents, the Nifty 500 offers greater sector diversification. It includes companies from various sectors such as IT, finance, healthcare, consumer goods, and more.
• Sensex: While it covers major sectors, it is less diversified compared to the Nifty 500. The Sensex is more concentrated in sectors like finance, IT, and energy.

Volatility

• Nifty 500: The broader market coverage means the Nifty 500 can be more volatile. It includes mid-cap and small-cap companies, which tend to be more volatile than large-cap companies.
• Sensex: Generally less volatile due to its focus on large-cap companies, which are typically more stable and less prone to large price swings.

Investment strategy

• Nifty 500: Suitable for investors seeking broad market exposure and willing to accept higher volatility. It provides a comprehensive view of the Indian equity market and can be a good option for long-term investors looking for diversification.
• Sensex: Suitable for investors looking for stability and lower volatility. It focuses on large-cap companies, which are generally more stable and have a proven track record. This makes it a good option for conservative investors.

Performance

• Nifty 500: The performance of the Nifty 500 can be influenced by the performance of mid-cap and small-cap companies. During bull markets, these companies can outperform large-cap companies, leading to higher returns for the Nifty 500. However, during bear markets, they can underperform, leading to lower returns.
• Sensex: The performance of the Sensex is primarily driven by large-cap companies. These companies tend to be more resilient during market downturns, providing more stable returns. However, during bull markets, the returns may be lower compared to indices that include mid-cap and small-cap companies.

In summary, the Nifty 500 and Sensex are two important stock market indices in India, each with its unique characteristics and advantages. The Nifty 500 offers a comprehensive view of the market with its broad coverage, while the Sensex provides a focused view of the top 30 companies. Understanding the differences between these indices can help investors make better-informed decisions and develop a more diversified investment strategy.

Pros and cons of investing in index mutual funds tracking Nifty 500

Pros:

Investing in a mutual fund that tracks the Nifty 500 index can be a smart move for many investors. Here are some of the key benefits:

1. Broad market exposure: As mentioned above, the Nifty 500 index includes the top 500 companies listed on the National Stock Exchange. This means that by investing in a mutual fund that tracks this index, you gain exposure to a broad cross-section of the Indian stock market. The index covers approximately 92% of the free float market capitalisation of stocks listed on the NSE.

2. Diversification: One of the primary advantages of investing in a Nifty 500 index fund is diversification. The index includes companies from various sectors and market capitalisations, including large-cap, mid-cap, and small-cap stocks. This diversification helps manage risk, as declines in one sector may be balanced by growth in another.

3. Long-term growth potential: Despite short-term market fluctuations, the stock market tends to trend upward over extended periods. Investing in a Nifty 500 index fund can be particularly beneficial for long-term investors who can withstand market volatility and potentially capitalise on the growth of the Indian economy.

4. Cost-effective: Index funds, such as those tracking the Nifty 500, are passively managed. This means they aim to replicate the performance of the underlying index rather than actively selecting stocks. As a result, they typically have lower expense ratios compared to actively managed funds, making them a cost-effective investment option.

5. Simplicity and convenience: Investing in a Nifty 500 index fund is straightforward. You don’t need to worry about selecting individual stocks or timing the market. The fund automatically adjusts its holdings to match the index, providing a hassle-free investment experience for passive investors.

6. Sectoral balance: The Nifty 500 index provides exposure to more than 20 sectors, including financial services, information technology, oil and gas, and fast-moving consumer goods. This sectoral balance ensures that your investment is not overly concentrated in a few sectors, reducing the risk associated with sector-specific downturns.

7. Accessibility: Mutual funds tracking the Nifty 500 index are accessible to a wide range of investors. Whether you are a first-time investor or an experienced one, these funds offer a balanced investment strategy that can suit various risk tolerances and investment goals.

Cons:

Investing in a mutual fund that tracks the Nifty 500 index has its advantages, but it’s also important to consider the potential drawbacks. Here are some of the cons:

1. Market risk: Index funds are subject to market risk, meaning their value can fluctuate based on the performance of the underlying index. If the Nifty 500 index experiences a downturn, the value of your investment will also decline. This can be particularly concerning during periods of market volatility.

2. Lack of flexibility: Index funds are passively managed, which means they aim to replicate the performance of the index rather than actively selecting stocks. This lack of flexibility can be a disadvantage if certain sectors or stocks within the index are underperforming. Active fund managers can adjust their portfolios to avoid such under performers, but index funds do not.

3. Limited potential for outperformance: Since index funds are designed to match the performance of the index, they have limited potential for outperforming the market. While this can be seen as a benefit in terms of consistency, it also means that investors may miss out on higher returns that could be achieved through active management.

Taxation of index mutual funds tracking Nifty 500

Investing in index mutual funds that track the Nifty 500 index can be a smart move, but it’s essential to understand the tax implications, especially after the changes introduced in the Budget 2024. It is important to note that Nifty 500 tracking mutual funds are classified as equity mutual funds and are taxed accordingly. Below is a detailed look at the taxation of these funds:

Capital gains taxation: The Budget 2024 brought significant changes to the taxation of mutual funds, including equity index funds. Here’s how capital gains are taxed:

• Short-term capital gains (STCG): If you hold the units for less than one year, the gains are considered short-term and are taxed at 20%.
• Long-term capital gains (LTCG): If you hold the units for more than one year, the gains are considered long-term and are taxed at 12.5% for gains exceeding ₹1.25 lakh in a financial year.

Impact of Budget 2024

The Budget 2024 has made several changes that impact the taxation of mutual funds. The tax rates for equity investments have increased for STCG as well as LTCG, making it essential for investors to plan their investments carefully. Understanding the tax implications of investing in index mutual funds tracking the Nifty 500 index is crucial for making informed investment decisions. The changes introduced in the Budget 2024 have made the tax landscape more complex, but with careful planning, investors can still benefit from the potential growth and diversification offered by these funds.

Conclusion

Investing in Nifty 500 tracking index mutual funds offers several advantages, including diversification, cost-effectiveness, transparency, and long-term growth potential. However, it also comes with certain drawbacks, such as limited flexibility, tracking errors, market risk, and limited alpha generation. Understanding these pros and cons can help investors make informed decisions and determine whether these funds align with their investment goals and risk tolerance.

Disclaimer: Investing in mutual funds involves risks, including potential loss of principal. Please consult with a financial advisor before making any investment decisions.

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