When exploring investment options, you would have come across the terms ‘index fund’ and ‘mutual funds’. While they may seem different, it is important to understand that there is no such thing as ‘index fund vs mutual fund’. In fact, index funds are a type of mutual fund. Mutual funds, in general, are categorised into two main types – actively managed funds and passively managed funds.
Actively managed mutual funds involve fund managers who aim to outperform the market through strategic investment decisions. On the other hand, passively managed funds, such as index funds, aim to replicate the performance of a specific market index. To help you better understand these investment options and make informed decisions, let us delve into the key differences and benefits of each approach.
An index fund is a type of mutual fund that replicates the components of a specific market index, such as NSE Nifty or BSE Sensex, in terms of the portfolio and asset allocation, aiming to closely match its performance.
Unlike regular mutual funds, you cannot customise an index fund or hand-pick individual securities. This is because index funds are passively managed, with the primary goal of mirroring a market index’s performance. This approach may lead to a tracking error, meaning a potential difference between the fund’s performance and that of the market index.
Here are some crucial advantages of investing in index funds:
An actively managed mutual fund is a type of mutual fund overseen by skilled and experienced managers who seek to beat the performance of a market index. These funds make investment decisions based on thorough research and analysis, which typically results in higher fees being charged, compared to passive funds.
Here are some crucial advantages of investing in actively managed mutual funds:
The following table shows a comparison of index fund vs actively managed fund:
Index fund vs Actively managed fund |
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Parameters |
Index Funds |
Actively Managed Funds |
Investment and Management Style |
Index funds take a passive approach, aiming to mirror a benchmark index (e.g., Nifty 50). It invests in the same stocks and in the same proportions as the chosen index, resulting in a hands-off investment style. |
Actively managed mutual funds involve fund managers actively selecting assets and adjusting their allocations based on research and market trends. This strategy relies on the fund manager’s skills, insights and expertise. |
Expense Ratio |
Index funds are generally low-cost, with minimal fund manager intervention, resulting in a much lower expense ratio. However, the exact percentage varies from one fund house to another. |
These funds incur higher expenses due to research, frequent adjustments and active management by fund managers. |
Performance |
Index funds aim to replicate the benchmark’s performance rather than exceed it. Studies indicate they tend to outperform actively managed funds over 80% of the time, especially in bearish markets. |
Actively managed MFs aim to outperform benchmarks, especially in rising markets. However, achieving this consistently is challenging, and performance may vary. |
Simplicity |
Index funds are simpler for investors, as they typically track a single index. Comparisons are mainly based on expense ratios and tracking errors, as performance is closely aligned with the underlying index. |
Selecting an actively managed MF requires a thorough analysis of factors such as the fund manager's past performance, AUM, and historical returns. |
Risk |
Risk in index funds is tied to the volatility of the index they follow. For example, Nifty 50-linked index funds tend to be less volatile than those tracking the Nifty Next 50, as the latter involves higher market fluctuation. |
The risk level depends on the market cap of the assets held. Large-cap MFs are more stable, while mid- and small-cap MFs may offer higher growth potential but with increased volatility. |
Among actively managed mutual funds and index funds, which is better for you depends on various factors. Here are the different factors you need to consider to determine which type of fund could be a better option for you:
If your goal is steady, long-term growth with minimal effort, index funds are often the better choice. These funds track market indices and offer predictable returns with low involvement from investors. They are ideal for those looking for broad, diversified exposure without the need for active decision-making. Alternatively, if you are seeking higher growth and are willing to accept more risk, actively managed mutual funds may be more appealing. These aim to outperform the market, providing the potential for higher returns.
Cost is also an essential consideration. Index funds tend to have lower fees due to their passive nature, making them more cost-effective for those focused on minimising expenses. Actively managed mutual funds usually ask for higher fees than passive funds, which can erode returns over time, though they might attract investors willing to pay a premium for the potential of higher gains.
It plays a key role in this decision. Index funds are typically better suited for risk-averse investors because they offer diversification and lower volatility. They provide a more stable option for those who want steady returns over the long run. Conversely, actively managed mutual funds are more volatile and are better for investors who can handle larger swings in performance and are comfortable with the possibility of higher risks in exchange for potentially greater returns.
Time horizon is another important factor. Index funds are ideal for long-term investors since they generally track the overall market’s performance and tend to grow steadily over time. However, actively managed mutual funds can be a good fit for both short and long-term goals, depending on the manager's strategy and the investor's risk profile.
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Transparency and tax efficiency favour index funds. These funds are more transparent because their holdings are regularly disclosed and tend to change less frequently. Index funds also have lower turnover, making them more tax-efficient as they generally incur fewer capital gains taxes. In contrast, actively managed mutual funds, due to their higher turnover and active management, can be less transparent and may generate more taxable events.
So, while both categories of mutual funds have their own merits, the decision to invest in actively managed mutual funds or index funds depends on your investment goals, risk tolerance and preferences. Ultimately, understanding the differences helps you make a more informed choice tailored to your financial requirements.