Your Questions Answered: I’m exploring index funds focused on the IT sector—What should I know?

I am a software developer working with a SAAS MNC in India. My wife is also a software developer working in another MNC. We have been investing in large-cap and mid-cap index mutual funds, we now wish to diversify our investments and invest in sectoral funds. We want to invest in the Information Technology (IT) sector. Are there any index funds investing in the IT sector? Additionally, please elaborate on the pros and cons of investing in mutual funds tracking such indices.

Anup Sharma, Gurgaon, Haryana

The Nifty IT Index is a pivotal benchmark for the Indian information technology sector, reflecting the performance of the leading IT companies listed on the National Stock Exchange (NSE). This index is a subset of the Nifty 50 Index, which is a broad-based benchmark index representing the Indian equity market. The Nifty IT Index offers investors and market intermediaries a precise measure of the IT segment's performance, which is crucial given the sector's significant contribution to the Indian economy. 

The Nifty IT Index comprises a basket of exchange-listed IT stocks that are engaged in a range of activities within the IT domain, including software development, IT services, and technology hardware. The selection of these companies is based on their market capitalisation, and they represent the cream of the Indian IT industry. The index is weighted by free-float market capitalisation, ensuring that only the market value of the freely tradable shares is considered, providing a more accurate reflection of the market dynamics.

Investment opportunities

The Nifty IT Index provides a gateway for investors looking to gain exposure to the Indian IT sector. It serves as an underlying for various financial products like mutual funds including Exchange Traded Funds (ETFs), futures, and options, allowing investors to trade or invest in the IT sector as a whole rather than individual stocks. This can be particularly advantageous for those seeking diversification in their investment portfolio.

Eligibility criterion of the Nifty IT Index

To be considered for inclusion in the Nifty IT Index, companies must meet a stringent set of eligibility criteria. These criteria ensure that the index accurately reflects the sector's performance and remains relevant to investors seeking exposure to the Indian IT market.

Nifty 500 membership: A primary requirement for a company to be eligible for the Nifty IT Index is that it should be a part of the Nifty 500 during the time of review/consideration. This criterion ensures that the company is already recognised as one of the top 500 companies by market capitalisation on the NSE.

Sector representation: The company must be categorised within the IT sector. This classification is crucial as the index aims to track the performance of companies engaged in Information Technology.

Trading frequency and history: The company should have a minimum listing history of one calendar month and maintain a 90% trading frequency as of the data cut-off date. These requirements are set to ensure that the company's stock is not only well-established but also actively traded, providing liquidity and stability to the index.

Minimum number of stocks: The index mandates that a minimum of 10 stocks be included. This rule is in place to maintain diversification within the index and to prevent over-concentration in a few stocks.

Market capitalisation and turnover: In scenarios where the number of eligible stocks from the IT sector within the Nifty 500 falls below 10, additional stocks are selected from the universe of companies ranked within the top 800 based on both average daily turnover and average daily full market capitalisation. This ensures that the index is composed of companies that are not only large in size but also have significant trading activity.

The Nifty IT Index operates on a semi-annual rebalancing schedule, reflecting changes in the market and ensuring that the index composition remains current. The index employs a free-float market capitalisation method, which considers only the company shares that are available for trading in the market, excluding promoter-held shares. 

The Nifty IT Index's methodology and eligibility criteria are designed to provide a transparent and robust benchmark for the IT sector. By adhering to these criteria, the index maintains its integrity and continues to be a reliable indicator of the Indian IT industry's performance.

Top constituents of the Nifty IT Index

The Nifty IT Index is a powerhouse of the Indian stock market, representing the pinnacle of the Information Technology sector's performance. In this detailed exploration, we delve into the top 10 constituents of the Nifty IT Index as of 30 August 2024, shedding light on the companies that are at the forefront of innovation and growth.

Tata Consultancy Services (TCS): TCS stands as a giant with a market cap that speaks volumes about its dominance. As a leading global IT service, consulting, and business solutions organisation, TCS has consistently shown resilience and growth, making it a favourite among investors.

Infosys Ltd: Infosys is synonymous with the rise of the IT sector in India. With its cutting-edge services and solutions, Infosys has carved out a significant presence in the global market, reflected in its robust market capitalisation and investor confidence.

HCL Technologies Ltd: HCL Technologies brings to the table a blend of engineering and software services, offering a comprehensive portfolio that spans key industries. Its market cap is a testament to its strong client relationships and innovative approach.

Wipro Ltd: Wipro's journey from a vegetable oil manufacturer to a leading IT company is a story of transformation. Today, it stands tall in the Nifty IT Index, showcasing its diversified IT services and strong market performance:

LTI Mindtree: As part of the prestigious Larsen & Toubro group, LTI Mindtree has made a mark with its technology consulting and digital solutions. Its inclusion in the top constituents reflects its growing influence and market position.

Tech Mahindra Ltd: Tech Mahindra represents the connected world, offering innovative and customer-centric IT experiences. Its place in the Nifty IT Index underscores its role in driving the digital transformation journey.

Persistent Systems Ltd: With a focus on software development and technology services, Persistent Systems has established itself as a key player in the IT landscape. Its market cap highlights its steady growth and potential

L&T Technology Services (LTTS): LTTS specialises in engineering and R&D services, pushing the boundaries of innovation. Its inclusion in the top 10 is indicative of its niche expertise and strong market presence.

Mphasis Ltd: Mphasis stands out with its next-generation technology solutions and services, particularly in cloud and cognitive services. Its market cap reflects its strategic focus and strong performance.

Coforge Ltd: Coforge's trajectory in the IT sector is marked by its deep domain expertise and micro-vertical strategy. Its position in the Nifty IT Index is a nod to its robust growth and market confidence.

Performance and returns and comparison with Nifty 50

As of August 30, 2024, the Nifty IT Index has given a one-year total return of 40.12%. It has given a 5 year compounded annual return of 21.73%. On the other hand, as of August 30, 2024, the Nifty 50 Index has given a one-year total return of 32.64%. It has given a 5 year compounded annual return of 19.39%.

Note: Past performance is not an indication of future returns.

Pros and cons of investing in index mutual funds tracking Nifty next 50 Index

Investing in mutual funds that track the Nifty IT Index can be an attractive option for investors looking to gain exposure to the Indian information technology sector, which is known for its rapid growth and potential for high returns.

Pros

Diversification: Mutual funds that track the Nifty IT Index offer investors a diversified portfolio of IT stocks. This means that investors can benefit from the growth potential of the IT sector while mitigating the risk associated with investing in individual stocks.

Professional management: These mutual funds are managed by professional fund managers who have the expertise and resources to analyse market trends and make informed investment decisions. This can be particularly beneficial for investors who may not have the time or expertise to manage their own investments.

Cost-effectiveness: Index funds are known for their lower expense ratios compared to actively managed funds. Since they simply track an index, there are no costs associated with research or frequent trading, making them a cost-effective investment option.

Liquidity: Mutual funds offer liquidity, meaning investors can easily buy or sell their fund units. This is particularly useful for investors who may need to access their funds on short notice.

Growth potential: The IT sector has been one of the fastest-growing sectors in India, with a significant contribution to the country's GDP. By investing in a mutual fund tracking the Nifty IT Index, investors can potentially enjoy higher returns compared to other sectors.

Ease of investment: Investing in a mutual fund is straightforward, and investors can start with relatively small amounts. This makes it accessible to a wide range of investors, from beginners to those with more experience.

Transparency: Mutual funds are regulated entities, and they offer transparency in terms of holdings, performance, and costs. Investors can easily track the performance of their investments and make informed decisions.

Systematic investment plans: Investors can opt for SIPs, which allow them to invest a fixed amount regularly. This not only instils financial discipline but also enables investors to benefit from rupee cost averaging and compounding over time.

Adaptability: The Nifty IT Index is regularly updated to reflect the changing landscape of the IT industry. This means that the mutual funds tracking this index are also updated, allowing investors to stay invested in the top-performing IT companies

Cons

Investing in a mutual fund that tracks the Nifty IT Index may seem like a sound strategy for those looking to tap into the potential of India's booming information technology sector. However, as with any investment, there are certain drawbacks that investors should consider before committing their capital.

Concentration risk: One of the primary concerns with investing in a mutual fund tracking the Nifty IT Index is the concentration risk. The Nifty IT Index is composed of a select group of stocks from the IT sector, which means that it lacks diversification across different industries. This can lead to increased volatility and risk, as the fund's performance is heavily dependent on the IT sector's market dynamics.

Sector specific risks: The IT sector, while lucrative, is also subject to rapid changes due to technological advancements, regulatory changes, and shifts in consumer behavior. These factors can significantly impact the companies listed in the Nifty IT Index, and consequently, the mutual funds tracking it. Investors may face the risk of obsolescence as new technologies can quickly outdate existing products and services.

Taxation

The Union Budget of 2024 has brought about significant changes in the taxation of investments, particularly in mutual funds tracking indices like the Nifty IT Index. Understanding these changes is crucial for investors who are looking to optimise their investment strategies in accordance with the new tax regulations.

Overview: The budget has streamlined the capital gains taxation, reducing the short-term capital gains (STCG) tax rate to 20% and the long-term capital gains (LTCG) tax rate to 12.5% for specific assets. This has increased the tax burden on investors in mutual funds tracking the Nifty IT Index, as it increases the tax burden on gains realised from these investments.

Impact on Nifty IT Index mutual funds: Mutual funds that track the Nifty IT Index are classified as equity mutual funds. As per the latest budget, for equity mutual funds, if the units are sold after a year from the date of investment, gains up to INR 1.25 lakh are exempt from tax. Gains exceeding INR 1.25 lakh are taxed at a rate of 12.5%. If the units are sold within a year, the entire amount of gain is taxed at the rate of 20%.

Conclusion

The Nifty IT Index is more than just a number; it's a reflection of the Indian IT sector's health and a barometer for the economy's technological progress. For investors, it offers a comprehensive view of the market's potential and challenges. As the IT industry continues to evolve with new technologies and innovations, the Nifty IT Index will remain an essential tool for market participants to gauge the sector's performance and make informed investment decisions. Investing in a mutual fund tracking the Nifty IT Index offers exposure to one of India's vibrant sectors. 

However, the pros and cons outlined above highlight the importance of a balanced and diversified investment approach. Investors should weigh drawbacks and benefits against their investment goals, risk tolerance, and the broader market outlook before making a decision. For those considering such an investment, it's advisable to consult with a financial advisor to ensure that it aligns with their overall portfolio strategy.

Kuvera is a free direct mutual fund investing platform. Unless otherwise stated data sourced from BSE, NSE and kuvera.