Category: Jargons

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Term Plan vs Endowment Plan vs ULIPs

What are Term Plans?

This is one of the oldest plans in the insurance industry. Term Plans only offer death benefits and no maturity benefits. If the policy expires and the insuree is still alive, then no benefits would be received by him/her. This plan provides pure financial protection to the family members of the policyholder. Premiums demanded in term plans are generally lesser than endowment plans or ULIP-linked plans.

What are Endowment Plans?

Just like a term plan, endowment plans offer a death benefit. But unlike term plans, these plans also offer some maturity benefits if the person insured is alive after the expiry date of the policy. These plans do not offer any investment portfolio but guarantee returns to the insured person or his family. The premium that is to be paid to the company is higher than what is paid in a term plan. A person can avail loans against his/her endowment plan. So, an endowment plan offers both ‘life + investment’ protection.

What are ULIPs?

Unit linked Insurance plans or ULIPs are a combination of insurance + investment. It is a perfect example of a hybrid model that offers both, life protection and the option to earn money via a good investment strategy. An individual insured under this policy will pay the premium which will be bifurcated into two parts.

One part of the premium is set aside for the insured person’s life insurance, while the other part is invested in the stock market. ULIPs are very flexible because they allow you to alter the proportional allocation of your investment and life insurance as per your wish.

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What are Derivatives

Derivatives are a type of contract between two or more parties whose value is based on an underlying financial asset. The underlying assets can be stocks, bonds, indices, currencies or commodities like gold, silver, oil, natural gas and many more.
Derivatives where created to manage the risk which is associated with the underlying asset. They can be used as speculating tool (high risk high reward) or Hedging (mitigating risk). There are three types of market participants in a derivatives scenario,

1. Hedger: A person who uses derivative instrument to reduce the risk in volatility of price changes in the underlying asset.
2. Speculators: They are willing to bear the risk and have a high-risk profile in order to obtain high rewards.
3. Arbitrageurs: They simultaneously enter into two or more markets to take an advantage of discrepancies between asset prices in those markets. Their margins are very low compared to other participants.
There are 4 broad type of derivative instruments: Forwards (OTC), Futures (Standardised), Options and Swaps.

Forwards – A forward contract is a customizable derivative contract between two parties to buy or sell an asset at a specific price on a specific future date. They do not trade on centralised exchanges and thus classified as Over-the-Counter (OTC) instruments.

Futures – A futures contract is a legally-binding agreement to buy or sell a standardised asset on a specific date or during a specific month. It is facilitated through an exchange and the contracts are standardised.

Options – An option contract is an agreement between two parties to facilitate a potential transaction to buy or sell an asset at a predetermined price on a predetermined future date. Buying an option offers the right, but not the obligation to purchase or sell the underlying asset.

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What is Monetary Policy?

Monetary Policy refers to the actions undertaken by a nation’s central bank to control the money supply in the system to achieve macroeconomic goals that promote sustainable economic growth.

Monetary Policy are largely of two types.

  • Contractionary Monetary Policy- Decreased money supply in the system.
  • Expansionary Monetary Policy- Increased money supply in the system.

Tools

The government uses certain instruments to control the supply of money in the economy. They are as follows.

  • Interest Rates: The RBI can influence the interest rates by controlling the base rate or the repo/reverse repo rate. If RBI increases the base rate, so will the banks and therefore money supply will decrease. Likewise, if RBI decreases the base rate, so will the banks, thereby increasing the money supply.
  • Reserve Requirement– Central banks usually set up the minimum amount of reserves that a commercial bank must hold. By changing the required amount, the central bank can influence the money supply in the economy. Example- Cash Reserve Ratio (CLR) and the Statutory Liquidity Ratio (SLR). Read More Here.
  • Open market operations- Open Market Operations is when the RBI involves itself directly and buys or sells government securities in the open market. This effectively affects interest rates.

Objectives

Inflation: A Contractionary Monetary Policy curbs high inflation by decreasing the supply of money. This decreases the demand for goods or basket of goods or consumer expenditure. Hence curbs inflation

Unemployment: An Expansionary Monetary policy curbs unemployment rates due to the increase in money supply which stimulates economic activity and thereby helps businesses flourish.

Exchange Rates: The central bank can influence foreign exchange rates by either increasing or decreasing supply in the economy. When the supply of money increases, the currency becomes cheaper and vice-versa.

There can be side effects of a change in monetary policy as well. For Example- When the government reduces the money supply in the economy to curb interest rates, the economic activity also goes down, which causes unemployment to go up. As you can see, the monetary policy is a very important tool for the economy. A slight change in monetary policy can have a huge impact on the economy and therefore needs to be dealt with caution.

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What is Credit Risk?

Amongst numerous types of risks an organisation faces, Credit Risk is the risk of default that a lender (organisation or an individual) faces when the counterparty fails to meet the terms of financial obligations. It is the possibility of losing the owed principle and interest amount, which will result in increased costs. It is calculated on the basis of the overall ability of the buyer to repay the loan. Generally, the higher the Credit Risk, the higher is the interest rate demanded by the entity for lending its capital.
Consumer Credit Risk can be measured by the 5 C’s of Credit Risk. Generally used by banks for lending out a loan and screening the loan application, NBFC and other financial services firms also use this to determine the risk associated with issuing a loan and estimating the credit-worthiness of a borrower.

1. Capacity – Measures a borrower’s ability to repay a loan by comparing income against recurring debts. It addresses the question, “Can the borrower generate adequate cash in order to repay the loans?”

2. Capital – It refers to the net worth or equity of a business or an individual. It suggests that the borrower adequately capitalised within industry standards to withstand unexpected loss.

3. Conditions – The economic, industry, and market environment can change the state of the borrower or the state of the economy. Is the borrower flexible enough to adapt?

4. Character – Moral integrity of credit applicant and whether the borrower is likely to give his/her best efforts to honouring credit obligation.

5. Collateral – Existence of assets (i.e. inventory, accounts receivable) that may be pledged by borrowing firm as security for credit extended.


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What are Open-Ended and Closed-Ended Funds?

What are Open-ended Funds?

Open-ended funds are the funds in which an investor can redeem their investment at any time he wants. Thus, the main characteristic of the fund is its liquid nature. Most of the investors want to invest in this type of fund. Open-ended funds form the biggest part of the mutual fund market. There are no limits on the number of units which can be issued.

These open-ended mutual fund units are bought and sold at their Net Asset Value or NAV. These funds are more suitable for investors who have less or no knowledge of the markets. An open-ended mutual fund’s NAV varies according to the performance of securities and its distribution inside a fund. Hence, they are prone to market risks and are highly volatile.

Top 5 Open-Ended Mutual Funds in India 2023

Fund Name5 Year Return
SBI Small Cap Fund25.1%
Mirae Asset Emerging Bluechip Fund21.19%
Motilal Oswal NASDAQ 100 Exchange Traded Fund22.04%
Aditya Birla Sun Life Banking & Financial Services Fund15.04%
ICICI Prudential Banking & Financial Services Fund13.93%
(Figures as of December 19, 2023)

What are Closed-Ended Funds?

Closed-ended funds are the funds which issue a fixed number of fund units. Unlike, open-ended funds, the investors can redeem their units only when the fund matures. Investors cannot purchase or redeem units of this type of fund once the NFO (New Fund Offer) has expired. Similarly to stocks, these funds are traded in the market.

Just like a stock is launched via an IPO, a new fund is launched via an NFO. Thus, these closed-ended funds can be liquidated only as per the fund norms and not as per the investor’s wish. As the investments are rigid, it gives more space to the portfolio managers to get a stable base of assets.

Top 5 Closed-Ended Mutual Funds in India 2023

Fund Name5 Year Return
Quant Tax Plan Direct Growth30.36%
Bandhan ELSS Tax Saver Fund Direct Plan Growth20.52%
Parag Parikh ELSS Tax Saver Fund Direct Growth24.67%
Kotak ELSS Tax Saver Fund Direct Growth19.18%
SBI Long Term Equity Fund Direct Plan Growth19.84%
(Figures as of December 2023)
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Gross Premium vs Net Premium vs Earned Premium

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Insurance is one of the major components of personal finance. Premium is something an insuree has to pay to the insurer to get the benefits when the norms of the policy are met. But, do you know premium as a term is itself very complicated? Here, we going to look at the term ‘premium’ and bifurcate it to get a better understanding.

Gross Premium

Quantum of new business done by an insurance company in one year is known as Gross Premium. This measures the new business’ amount earned by a company in one year. Another name of Gross Premium is Written Premium.

For example, suppose an insurance company, ABC Life, gets 1000 new customers in one year. All 1000 of them buy the same policy which requires them to pay Rs 100 each in a year. Then ABC Life’s Gross Premium of that particular year will be 1000 x 100 = Rs 1,00,000. 

Net Premium

Insurance is a risky business. An insurance company takes the risk of their insuree upon themselves in return for some pre-decided amount (premium). No one can predict perfectly that the insuree will meet the norms of the policy and raise a claim. Thus, an insurance company face various kinds of risks.

To limit their risk, these insurance companies take the help of a reinsurance company. These reinsurance companies charge a part of premium from insurance companies and take some part of the risk on themselves. If the insuree files a claim, both the reinsurance and insurance companies are liable to pay the benefits in a proportion decided earlier. 

Earned Premium

It represents premiums earned on the part of an insurance policy which has expired. Premiums which are collected for an active portion of an insurance policy are considered unearned premiums.

Earned premiums can be used to pay for expenses but unearned premiums still posses the risk that the insuree can file for a claim. Thus, the earned premium becomes a very important metric.

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What are Dividends? How Do They Work?

what are dividends? | marketfeed

A dividend is a reward a company gives its shareholders at regular intervals, generally from its profits. Listed companies usually pay dividends in cash and are an additional source of income for shareholders. In this article, we will understand what dividends are, how they are distributed, and a few must-know topics related to dividends. We will also discuss what you should do with dividends and how reinvesting it can accelerate your compounded returns.

What is a Dividend?

A dividend is a payment made by a company out of its earnings or accumulated profits to its shareholders. When companies distribute dividends, it gives the shareholders a proportion of their earnings. The amount paid to each shareholder depends on the number of shares they own. Dividends are declared on a per-share basis. The amount paid to each shareholder will be proportional to the number of shares held. When companies consistently pay dividends over time, it signals that the company is growing and has abundant cash.

To learn more about the highest dividend-paying stocks in India, click here.

Why Do Companies Pay Dividends?

1. Attract Investors: Most investors like to receive steady cash income in the form of dividends as it becomes a secondary source of income. Therefore, more investors will be likely to buy the company’s stock.

2. Rewarding Shareholders: Dividends also act as a reward for investors for investing and showing their faith in the company.

3. Financial Strength: Investors view dividend payments as a sign of a company’s financial strength and a sign that management has positive expectations for future earnings. This also makes the company more attractive to investors.

Do all Companies/Stocks Pay Dividends?

The decision to pay dividends is completely up to the company’s discretion. Companies are not legally required to distribute profits. It can either pay dividends from its profits or invest more into itself for business expansion. Therefore, young and growing companies typically don’t pay dividends.

Usually, only mature and established cash-rich companies pay dividends. These companies have surplus cash and maintain consistent cash flow sources. However, some mature companies can also choose not to distribute dividends if they feel that investing more to expand their business will add more value to shareholders than paying dividends. 

Types of Dividends

The two most common types of dividends are cash dividends and stock dividends.

Cash Dividends

In cash dividends, companies pay the dividend in cash. The shareholders will receive the cash directly to their registered bank accounts. 

Stock Dividends

In stock dividends, companies pay the shareholders additional shares in the company instead of cash. Stock dividends dilute Earnings Per Share (EPS). [EPS indicates a company’s profitability by showing how much money a business makes for each share of its common stock].

When are Dividends Paid?

Dividends can be paid quarterly, biannually, or annually. However, most companies pay dividends every quarter. They can also pay a special dividend, which occurs outside the regular dividend frequency. The frequency of dividend payments is determined by the company’s management.

Important Dividend Dates

To understand the timelines of dividend payments, there are a few dates that you should learn about:

1. Declaration Date: The day a company officially announces or communicates about the next dividend payment to its shareholders.

2. Record Date: It is the date within which a person should own the shares to be eligible for receiving dividends. The company will collect information about its shareholders as of the record date to determine eligible shareholders. If you have a stock in your holdings as of the record date, you will receive a dividend from the company.

3. Ex-Dividend Date: The ex-dividend date or “ex-date” is the day the stock starts trading without the value of its next dividend payment. Typically, the ex-dividend date for a stock is one business day before the record date, meaning that an investor who buys the stock on its ex-dividend date or later will not be eligible to receive the declared dividend. It is because of the T+1 settlement in the Indian stock market. 

4. Payment Date: The payment date is the date on which the dividend is actually paid out to shareholders.

Process of Distributing Dividends

Here’s a basic outline of how a listed company distributes dividends:

Dividend Proposal and Board Approval

A company first evaluates if it is in a position to issue dividends. If yes, the company’s Board of Directors will consider a dividend proposal and put it to a vote. The management considers various factors, including its future capital needs and the interest of shareholders.

Dividend Declaration

The company’s board announces the dividend distribution on a specific date known as the declaration date. On this day, the company reveals the dividend amount per share and the record date.

Record Date

The record date is the date on which the company determines which shareholders are entitled to receive the dividend. Shareholders as of the record date will receive the dividend, and their names will be listed in the company’s records.

Dividend Payment

The payment date is when the actual dividend is distributed to eligible shareholders. On this day, the company disburses the dividend payments. The company will deposit the dividend directly to the shareholder’s bank account.

An Example of Dividend Payment

Companies always declare dividends on a per-share basis. Let’s assume that Reliance Industries Ltd (RIL) declares a dividend of ₹30 per equity share. Then, an investor holding 50 shares of RIL as of the record date will receive ₹50 for each share the investor holds.

Therefore, the investor will receive:

50 x ₹30 = ₹1,500

Why are Dividends Important?

  • Some companies even offer a Dividend Reinvestment Plan or DRIP. It allows a shareholder to reinvest the dividends back into the company buying its stocks usually at a discount or zero commission.
  • Studies have consistently shown that dividend-paying stocks outperform non-dividend-paying stocks during a bearish market.
  • It helps protect your investment from inflation. To know more, click here.
  • Dividends act as a great source of passive income.
  • Depending on the amount you wish to invest, there are certain tax benefits involved in the income earned from dividends.

What are the Ratios Related to Dividends?

All investors must be aware of these two ratios to analyse the various aspects of dividends:

Dividend Payout Ratio

The dividend payout ratio represents the proportion of earnings paid out as dividends. A lower payout ratio indicates that the company retains a sizeable portion of its earnings for reinvestment or future growth, which can be positive for long-term stability. On the other hand, a high payout ratio may indicate that the company is distributing a significant portion of its profits, potentially limiting its ability to invest in growth opportunities or withstand economic downturns.

Payout Ratio = Dividends Per Share/Earnings Per Share × 100, or

Payout Ratio = Dividends Per Share/Free Cash Flow Per Share × 100

Dividend Yield Ratio

The dividend yield ratio of a share is the ratio of the annual dividend per share to the share’s market price. It evaluates the dividend amount relative to the stock price. A higher dividend yield may indicate a potentially attractive income-generating opportunity. However, the dividend yield ratio is dynamic, as the value ratio changes with the stock price. It is essential to compare the yield with industry peers and assess its sustainability. The higher the dividend yield, the better it is for the shareholder.

Dividend Yield Ratio = Cash Dividend Per Share / Market Price Per Share x 100

How Do Dividends Affect a Stock’s Share Price?

The declaration and payment of dividends have a specific and predictable effect on market prices. After the ex-dividend date, the share price of a stock tends to drop by the amount of dividend declared.

For example, if a company issues a dividend of ₹5 per equity share, the share price also tends to fall ₹5.

What Should You Do With Dividends?

You can either reinvest dividends or use them for your personal expenses. However, choosing between them depends on your investment goals. Reinvesting dividends helps grow your investments exponentially faster.

Investors who only consider price appreciation overlook an important source of return: the compounding that results from reinvested dividends. Reinvested dividends are cash dividends that the investor receives and uses to purchase additional shares. In the long run, the compounding effect of reinvested dividends significantly impacts the total returns on equity securities.

For example: Between 1900 and 2016, $1 invested in US equities in 1900 would have grown in real terms to just $11.9 when taking only the price appreciation or capital gain into account. However, it would’ve surged to $1,402 with reinvested dividends. This corresponds to a real compounded return of 6.4% per year with dividends reinvested, versus only 2.1% per year without dividends reinvested.

Taxation of Dividends

  • Until March 31, 2020 (FY 2019-20), dividends received from an Indian company were exempt from taxation. That was because the company declaring such a dividend already paid dividend distribution tax (DDT) before making payment. 
  • However, the Finance Act of 2020 changed the method of dividend taxation. Going forward, all dividend received on or after April 1, 2020, is taxable in the hands of the investor/shareholder. 
  • The Finance Act of 2020 also imposes a Tax Deducted at Source (TDS) on dividend distribution by companies and mutual funds on or after April 1, 2020.
  • The normal rate of TDS is 10% on dividend income paid in excess of ₹5,000 from a company or mutual fund.
  • The tax deducted will be available as a credit from the total tax liability of the taxpayer while filing Income Tax Returns (ITR). 
  • For non-resident persons, TDS is required to be deducted at the rate of 20%.
  • The act also allows the deduction of interest expense incurred against the dividend. The deduction should not exceed 20% of the dividend income received.

In conclusion, investing in dividend-paying stocks can be a great source of passive income. While investing, it is crucial to look beyond the absolute dividend values and consider other factors such as dividend payout ratios. This investing style is best suitable for people who are seeking a regular cash flow!

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What is Cash Flow Statement?

share market today

The statement of cash flows is one of the most important financial statements, if not the most important. It acts as a bridge between the Balance Sheet and Profit & Loss statement to let the analyst know where the cash has been used. It tells what is the source of cash and where is its application. Cash is the most liquid form of asset for any company. Any entity with poor cash flow management can go bust within years.

The Structure

The three components of Cash Flow Statements are:

  1. Cash from operating activities

It reflects how much cash is generated from a company’s core business. Activities pertaining to the core business of a company is known as operating activities. Example of operating activities are:

  • Salaries paid out to employees
  • Interest income and dividends received
  • Income tax paid and interest paid
  • Display advertisements to attract new customers

2. Cash from investing activities: Just like individuals, a company also makes certain investments to take benefits in the future. The cash inflows and outflows pertaining to investment comes in this criterion. Cash flows from buying and selling long-term assets are also counted in this criterion. Example of Investing activities are:

  • Proceeds from the sale of PP&E.
  • Acquisitions of other businesses
  • Purchases of marketable securities
  • Sale of fixed assets

3. Cash from financing activities: Activities such as issuing dividends, paying interest to debt taken and raising fresh debt, etc come under this criterion. Any change in equity capital and borrowing is included in this segment. Example of financing activities are:

  • Repayment of existing loans
  • Sale of treasury stock
  • Paying cash dividends on its capital stock
  • Cash from new stock issued
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Exchange-Traded Funds: What are they?

Exchange-Traded Funds or ETFs are listed and traded on exchanges like stocks. It is a fund that pools the financial resources of several people and uses it to purchase shares, bonds, derivatives, etc. The trading value of an ETF is based on the net asset value (NAV) of the stocks that are present in the fund. Thus, an Exchange-Traded Fund is said to have qualities of both shares and mutual funds.

One of the main benefits of ETF is diversification. When an investor invests in a stock, he does not have a space to limit his risk. If the company fails to perform, the investor will make losses. Now, an ETF helps you to keep your finances spread over the equities of different companies. If one of the stocks performs poorly, other stocks might act to limit the risk exposure by performing well. If other assets perform exceptionally well, an investor would still be earning profits.

Exchange-Traded Funds vs Mutual Funds

Exchange-Traded FundsMutual Funds
Market orders can be placedMarket orders cannot be placed
Traded intra-day like stocksTraded at the end of the day
Generally, a lower expense ratio than
mutual funds		Generally, a higher expense ratio when
compared to ETFs

Common types of ETFs

Gold ETF – Gold is a commodity. This makes the ETF a commodity ETF. A gold ETF is based on gold prices and it invests in gold bullion. Purchasing shares in this ETF makes you a virtual owner of gold.

Equity ETF – As the names suggest, these ETFs invest in the shares of different companies to earn interest and reduce risk exposure.

Currency ETF – The main objective of a currency ETF is to reduce the exposure to foreign exchange (forex) currencies.

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What is an Index Fund? A Complete Guide to Index Funds in India

what is an index fund | marketfeed

If you are a beginner in the stock market or a conservative investor, index funds can be a great way to diversify your investment portfolio with minimal cost and effort. In this article, we’ll cover everything you need to know about index funds, starting from the basics to choosing the suitable one. We will also discuss how it differs from actively managed funds.

What is an Index Fund?

An index fund is a type of mutual fund or exchange-traded fund (ETF) that tracks and replicates the performance of a specific market index (like NIFTY50/Sensex in India or S&P500 in the US). These funds replicate the performance of an index regardless of the state of the markets. When you invest in an index fund, you automatically own a tiny piece of all the companies in the index. So, if the companies in the index perform well, your investment does too. These funds provide exposure to the broad market at a low cost.

Veteran investor Warren Buffet has recommended index funds as an investment option to park savings for retirement. He argues that investing in an index fund is more sensible for an average investor than picking and investing in individual stocks. This is because index funds provide exposure to the market as a whole.

How do Index Funds Work?

Consider an index fund that replicates/tracks NSE’s Nifty50 Index. There will be 50 stocks in this fund’s portfolio, all of which will have the same weightage as in Nifty50. When you put money in this index fund, that cash is used to invest in every company that makes up the particular index. It gives you a more diverse portfolio than if you were buying individual stocks. The fund’s value rises and falls in sync with the index it’s based on.

The low expense ratio of an index fund is one of its main unique selling points (USPs). The expense ratio is a small portion of the fund’s total assets that the fund house charges investors for fund management services.

Benefits of Investing in Index Funds

A few of the benefits of Index funds compared to individual investment in stocks are:

1. Diversification

By investing in an index fund, you gain exposure to a broad range of assets (stocks or bonds) within the chosen index. All indices other than sectoral indices are well-diversified, and you can reduce the risk of one stock performing poorly.

2. Lower Cost

Index funds are known for their low expense ratios, meaning they have lower fees compared to actively managed funds.

3. Historical Performance

Over the long term, index funds tend to match or outperform many actively managed funds.

4. Time Saver

Investors don’t have to spend hours researching stocks since the stocks in index funds are copied from the index in the same proportion.

5. Transparency

Index funds provide full transparency into their holdings, allowing investors to see exactly what they own.

Types of Index Funds

There are index funds available for a wide range of market indices, covering different asset classes and regions. Here are some common types:

1. Equity Index Funds

These track stock market indices like the Nifty50 and Sensex. In the past, large-cap stocks have generally outperformed inflation. But they have also shown significant volatility over short and medium-term timeframes.

2. Bond Index Funds

Bond index funds replicate the performance of bonds or fixed-income securities. For example, the S&P BSE India Bond Index tracks local currency-denominated government and corporate bonds from India. This type of index fund is ideal for investors looking for stability in investments and regular interest payments.

3. Sectoral Index Funds

Sectoral index funds provide exposure to specific sectors of the economy like banking, technology, healthcare, or real estate. For example, an index fund based on Nifty Financial Services is a sectoral index fund that tracks the performance of financial services companies in India.

However, these funds are generally riskier than diversified funds because they are more narrowly focused. The fund’s performance relies on how well that particular sector does.

4. Global Index Funds

Global index funds invest in global indices such as the S&P500 and NASDAQ 100. These funds offer an opportunity to easily invest in multi-national companies. 

5. Commodity Index Fund

Commodity Index Funds track commodity indices. You can invest in commodities such as gold, oil, or agricultural products easily through these funds.

How to Choose the Right Index Fund?

Selecting the right index fund is crucial for achieving your investment goals. A few points to keep in mind while choosing an index fund are:

1. Determine Your Goal 

The first step before choosing an index fund is to determine your investment goal. College fees, buying a dream car or home, securing retirement funds, etc. can be examples of investment goals. Your goal will influence which index fund is best for you.

2. Risk Tolerance

Consider how comfortable you are with risk. If you prefer lower risk, consider bond index funds. On the other hand, if you can handle some fluctuations (volatility) in your investments, equity index funds might be the better choice for you.

3. Expense Ratios

Compare the fees across various index funds. Lower fees result in more of your money being invested. The expense ratio is a metric that reflects the fees and additional costs you incur with the mutual fund company.

4. Track Record

Check the fund’s historical performance. While past performance doesn’t guarantee future results, it can provide valuable insights. It’s important to note that the performance of an index fund will never exceed the chosen index because expenses reduce the overall returns it generates.

5. Diversification

Ensure the index fund aligns with your desired level of diversification for your investment portfolio.

Index Fund vs Actively Managed Funds

The key differences between index funds vs. actively managed funds are:

Index FundsActively Managed Funds
Replicates the holdings of a specific indexFund managers make decisions based on research and analysis
Expense ratio is generally lower due to passive managementExpense ratio will be higher due to active management and research costs
Lower risk due to broad diversificationRisk varies depending on the fund manager’s decisions
Discourages market timing, focuses on long-term investingMay involve market timing and tactical allocation
Generally aims to match the performance of the indexSeeks to outperform the market or a benchmark index

Historical Performance of Index Funds

Index funds typically deliver returns that closely mirror the performance of the underlying indices they track. Looking at historical data, it’s evident that the majority of actively managed funds have struggled to outperform these indices, which is why many investors opt for index funds.

Over the past 30 years, index funds based on the S&P 500 have delivered a Compounded Annual Growth Rate (CAGR) of 10.7% per year. Meanwhile, index funds based on Nifty50 have given a return of 12% CAGR in the last 15 years.

To learn more about the best index funds to invest in India, click here.

How to Invest in Index Funds in India

Here’s a simple guide on how to invest in index funds in India:

  1. Start by selecting a reliable brokerage platform (like Zerodha or Groww). Ensure that the broker offers access to a variety of index funds.
  2. To invest in index funds, you’ll need a Demat and trading account. These accounts will hold your investments electronically and enable you to buy and sell index fund units.
  3. Research and pick an index fund that aligns with your investment goals and risk tolerance. Popular choices include Nifty 50 index funds, Sensex index funds, and sector-specific index funds.
  4. Use your broker’s trading platform to place buy orders for the index fund you’ve chosen. Specify the number of units or the amount you wish to invest.
  5. Index funds are designed for long-term investing. Stay committed to your investment strategy and avoid making impulsive decisions based on short-term market fluctuations.

Tax Considerations on Index Funds

Taxes on index funds are levied both on capital gains and dividends. Dividends are combined with the investor’s taxable income and taxed according to their income category. Capital gains, on the other hand, are subject to separate taxation.

Read: Income Tax Structure for Stock Market Investors & Traders.

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What is EBITDA?

EBITDA, or earnings before interest, taxes, depreciation, and amortization is a measure of a company’s overall financial performance and is used as an alternative to the net income in some circumstances. It is a measure of profitability.

Amortization refers to spreading payments over multiple periods in case of debt. It also refers to a reduction in the value of intangible assets such as goodwill, a patent, or a copyright.

Depriciation on the other hand refers to the decrease in value of a tangible asset (Car, Bike, Machinery) with time.

How Do I Calculate EBITDA?

EBITDA= Net Income + Interest + Taxes + Depreciation + Amortization

EBITDA = Operating Profit + Depreciation expense + Amortization expense​.

Operating Profit = The profit earned from the business operation before the deduction of taxes and payable interest.

Why EBITDA?

EBITDA is to be used to analyze and compare profitability among companies and industries. It eliminates the effects of financing and capital expenditures.

  • Financing expenditures are essentially the interest, and other charges involved in the borrowing of money to build or purchase assets.
  • Capital expenditures (capex) are funds used by a company to acquire or upgrade physical assets such as property, buildings, or equipment.

The EBITDA metric is commonly used as a proxy for cash flow. It can give an analyst a quick estimate of the value of the company, as well as a valuation range by multiplying it by a valuation multiple obtained from equity research reports, industry transactions, or M&A.

In addition, when a company is not making a profit, investors can turn to EBITDA to evaluate a company. Many private equity firms use this metric because it is very good for comparing similar companies in the same industry. Business owners use it to compare their performance against their competitors.

Drawbacks of EBITDA

Ignores Costs of Assets

Unlike Free Cash Flow (FCF), every company needs a certain amount of money to ensure that its operations continue to run. One such example is when a textile loom buys a machine, it needs to pay for transportation, labour wages, installation and testing of the machine.

Ignores Working Capital

EBITDA also leaves out the cash required to fund working capital (the capital of a business which is used in its day-to-day trading operations) and the replacement of old equipment

Varying Starting Points Make It Unreliable

While subtracting interest payments, tax charges, depreciation, and amortization from earnings may seem simple enough, different companies use different earnings figures as the starting point for EBITDA. In other words, EBITDA is susceptible to the earnings accounting games found on the income statement.

What is EBIT? How is it Different From EBITDA?

EBIT or Earnings before interest and taxes is a measure of a firm’s profit that includes all incomes and expenses except interest expenses, income tax expenses, amortization and depreciation.

EBIT = Net Income + Interest Expense + Tax Expense

EBITDA is particularly useful in cases of firms with very heavy capital investments. In these cases, depreciation and amortization can make the company’s operating budget look far less healthy than it actually is, even to the point of showing operating losses despite a steady cash flow.

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What is Dividend Yield?

Dividend Yield

Dividend Yield is a financial ratio that tells how much a company pays out in dividends each year in comparison to its stock price. It measures the cash dividend paid out to the shareholders relative to the market price of the share.

Understand Dividend Yield

Company has shareholders whose primary interest to earn income, either in the form of capital appreciation or dividends. Thus, to keep its shareholders happy, the company tends to pay dividends to its shareholders. This dividend is generally paid from the portion of profit which the company earns. The rest of the amount left which is not distributed goes into the retained earnings. Mature companies are the most likely to pay dividends.

Thus, it is a metric which tells about how much the shareholders are earning from their investment in a certain company. Higher the dividend yield, better it is for the shareholder.

Example

Suppose a company ABC has a stock price of Rs. 100 and announces a dividend of Rs. 5. Then dividend yield would be,

Dividend Yield = Cash Dividend per share / Market Price per share * 100

DY = (5/100)*100 = 5%