Your Questions Answered: I want to invest in sectoral index mutual funds. Please elaborate on the Nifty Auto Index

Q. I am a small businessman from Shillong, I own 2 small hotels. My wife is a housewife. We have been investing in index mutual funds tracking Nifty 50 and Sensex. We now intend to diversify and invest in sectoral index mutual funds. In my opinion, the auto sector will continue to show resilient growth in the long run. Can you please elaborate on the nuances of the Nifty Auto Index and the pros and cons of investing in index mutual funds tracking the Nifty Auto Index?

Matthew Nongbri, Shillong, Meghalaya

The Nifty Auto Index is a pivotal sectoral benchmark reflecting the health, performance and behaviour of the Indian automobile sector. This index was established by the National Stock Exchange (NSE) with a base date of January 1, 2004, indexed to a base value of 1000 (This value is a standardised convention for easy comparison and tracking of performance over time).

The Nifty Auto Index is computed using the free float market capitalization method, which offers a realistic snapshot of market movements. The constituents are a mix of heavyweight automotive companies and auto component manufacturers, which are periodically reviewed to ensure they accurately represent the industry's current state.

The Nifty Auto Index’s performance is closely monitored by investors and analysts, as it provides insights into the sector's health and the economy's overall direction.

For example, a rise in the Nifty Auto Index could signal increased consumer confidence and income level, resulting in higher car sales and profitability for auto sector companies. On the other hand, a decline in the Nifty Auto Index might reflect a declining economy, policy changes, or shifts in consumer preferences.

Investors use the Nifty Auto Index to invest in the auto sector, often using index funds that track its performance. These index funds allow investors to invest in a sector without undergoing the difficult task of picking individual stocks in the auto sector.

It also serves as a barometer for the auto industry's future. The past few years have witnessed a remarkable acceleration in the electric vehicle and sustainable transportation sectors. Companies that adapt to these emerging trends and innovate are likely to see their stock prices get positively affected in the index. On the other hand, companies that fail to evolve, which often leads to a weakening of their financials may see a reduction in their weightage in the index.

Index constituents eligibility criterion

To qualify for inclusion in the Nifty Auto Index, a stock must fulfil a set of established eligibility requirements. The essential criteria for selection are:

Part of Nifty 500 universe: The company must already be a part of the broader Nifty 500 universe. If the number of eligible auto sector companies within the Nifty 500 universe drops below 10, the remaining slots will be filled by selecting companies from the top 800 universe, based on their average daily turnover and market capitalization.

Sector classification: For a company to be included in the Nifty Auto Index it must operate within the defined "Automobile" sector. The Automobile sector comprises various sub-sectors, such as passenger cars, commercial vehicles, auto components, tires, and several more.

Trading frequency: For a company to be included in the Nifty Auto Index its stocks must demonstrate a trading frequency of at least 90% in the past six months. In order to ensure that the stock is actively traded and liquid.

Listing history: The company should have a minimum listing history of 1 month as of the cutoff date.

Market capitalisation and weights: The last criterion for the selection of companies is their respective weight determined by the free-float market capitalization method. To ensure diversification, it is ensured that no single company can account for more than 33% of the index's total weight, and the cumulative weight of the top three companies cannot exceed 62%.

What is the significance of these eligibility criteria?

The above-mentioned criteria are relevant because of the following reasons:

Representation: This ensures that the Nifty Auto Index truly represents the diverse landscape of the Indian automobile industry.

Liquidity and stability: The trading frequency and market capitalization requirements ensure that the index consists of only actively traded stocks, which reduces volatility and makes it a more reliable benchmark.

Growth potential: By only selecting the companies with strong market capitalization and trading activity, the Nifty Auto Index reflects the auto sector's actual growth prospects.

Investment tool: The index most importantly serves as a valuable tool for investors looking to gain exposure to the automotive sector, through index funds that allow them to track its performance.

Past performance

As of July 25, 2024, the Nifty Auto Index has given a one-year return of 62.55%. It has given a 5 year compounded annual return of 29%. Here are two index funds that track the Nifty Auto Index:

Source: AMFI; all data calculated as of July 25, 2024

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

Pros of investing in a Nifty Auto Index fund

Diversification within the auto sector: This index comprises various companies involved in vehicle manufacturing, including cars, trucks, and two-wheelers, as well as ancillary industries. Diversification provided by index funds that track the Nifty Auto Index can help mitigate risks associated with individual company performance.

Sector-specific exposure: For investors with a bullish outlook on the auto sector, this offers an opportunity to tap into the sector's growth potential without the complexity of selecting individual stocks.

Passive investment strategy: Index funds are known for their passive management. By tracking an index, these mutual funds aim to replicate the performance of the index they track, thereby eliminating the need for any kind of active stock selection and potentially reducing management fees.

Cons of investing in a Nifty Auto Index fund

Sector concentration risk: Sector-specific exposure also comes with the inherent risk of concentration. If the auto sector faces downturns due to economic cycles, inflation, or technological disruptions, investors may experience significant losses.

However, to mitigate these risks, investors can diversify their portfolios across different sectors and asset classes. Additionally, investing in index funds or ETFs can provide broader sector exposure, and regularly rebalancing the portfolio can help maintain target allocations. This will allow investors to reduce their reliance on a single sector and minimise potential losses while still benefiting from the growth opportunities in the auto sector.

Who should consider investing?

The following types of investors may benefit from investing in index mutual funds tracking the Nifty Auto Index:

Long-term investors: Investors who have a long-term horizon can consider funds that track the Nifty Auto Index. Investing for the long term can help mitigate short-term volatility.

Risk-tolerant investors: Given the sector-specific nature of these index funds, they tend to be typically more volatile than diversified equity funds. Investors who have a higher risk appetite and can withstand market fluctuations from time to time may find these index funds suitable.

Thematic investment enthusiasts: Those familiar with the auto sector, who favor thematic investing, and are bullish on the Indian auto industry's growth prospects, may find these funds appealing. It allows them to bet on the sector without having to pick individual stocks.

Factors to consider before investing

Market conditions: Before investing in an index fund, one should assess the current market conditions and the outlook for the auto sector. Factors pertinent to the auto sector such as government regulations, raw material cost, and technological advancements play a crucial role in shaping the auto industry's future.

Expense ratio: As with any kind of mutual fund, the expense ratio is an important consideration. Since these are passively managed funds as stated above, the expense ratio is typically lower compared to active funds. It is crucial to choose a fund with a competitive expense ratio to maximise returns on your investment.

Tax implications

Understanding the tax treatment of investments in Nifty Auto Index Funds is crucial for optimising returns, and the key tax implications are outlined below:

Taxation on capital gains

The taxation of investments made in funds tracking the Nifty Auto Index is governed by the rules applicable to equity-oriented mutual funds in India. The tax treatment depends on the duration for which the investments are held, classified into Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG).

Short-term capital gains: If the units of the mutual fund are sold within one year from the date of investment, any profit realised is considered as STCG. These gains are taxed at a flat rate of 20%, regardless of the investor's income tax slab.

Long-term capital gains: For units sold after being held for more than one year, the gains are classified as LTCG. Investors enjoy an exemption on gains up to INR 1.25 lakh per financial year. Any gains exceeding this threshold are taxed at a flat rate of 12.5%, without the benefit of indexation.

Conclusion

Nifty Auto Index tracking mutual funds offer a focused investment strategy for those who are bullish on the Indian automobile sector. However, it's imperative to align this investment with one's financial goals, risk tolerance, and investment horizon. Investors should conduct thorough research or consult with a financial advisor to make an informed decision.

Investors must also weigh the benefits of targeted sector exposure and passive management against the risks of sector concentration and limited broader market diversification. As with any investment, it's essential to consider your financial goals, risk tolerance, and investment horizon before making a decision.

Thoughtfully investing in sector-specific index funds as part of a diversified portfolio can be a rewarding strategy. As the Indian auto sector gears up for a new era of innovation and growth, index funds that track the Nifty Auto Index could be one of the vehicles to drive your investments forward.

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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