Index Funds Vs Mutual Funds - Top Key Differences

28 November 2024
6 min read
Index Funds Vs Mutual Funds - Top Key Differences
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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.

What are Index Funds?

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.

Benefits of Index Funds

Here are some crucial advantages of investing in index funds:

  • Cost-effective: Index funds tend to charge lower fees compared to actively managed funds. The reduced expense ratio means more of your money goes toward the investment.
  • Easy to Track: Tracking the performance of index funds is straightforward, as they closely mirror the market index, making it easy to understand how they are performing.
  • Diversification: Investing in index funds provides instant diversification, allowing you to tap into a wide range of top-performing stocks across various sectors.
  • Potential for Higher Returns: Over the long term, index funds may outperform actively managed funds, as their returns are not influenced by subjective decisions or biases.

What are Actively Managed Mutual 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. 

Benefits of Actively Managed Mutual Funds

Here are some crucial advantages of investing in actively managed mutual funds:

  • Professional Management: Skilled fund managers make investment decisions, using their expertise, aiming for the best possible returns.
  • Liquidity: Investors can easily buy or sell the mutual fund units, thanks to their high liquidity.
  • Regulation and Oversight: Regulatory bodies monitor mutual funds to ensure transparency, accountability and alignment with investor interests.
  • Diversification: Mutual funds distribute the investments across various assets, thus building a diversified portfolio, and reducing the risks.

Differences Between Index Funds and Actively Managed Funds

The following table shows a comparison of index fund vs actively managed fund:

Index fund vs Actively managed fund

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.

Index Fund Vs Actively Managed Mutual Fund: Which is Better?

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:

  • Investment Goals

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.

  • Management Cost

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.

  • Risk Tolerance 

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.

  • Investment Horizon

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

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.

Disclaimer

The stocks mentioned in this article are not recommendations. Please conduct your own research and due diligence before investing. Investment in securities market are subject to market risks, read all the related documents carefully before investing. Please read the Risk Disclosure documents carefully before investing in Equity Shares, Derivatives, Mutual fund, and/or other instruments traded on the Stock Exchanges. As investments are subject to market risks and price fluctuation risk, there is no assurance or guarantee that the investment objectives shall be achieved. Groww Invest Tech Pvt. Ltd. (Formerly known as Nextbillion Technology Pvt. Ltd) Ltd. do not guarantee any assured returns on any investments. Past performance of securities/instruments is not indicative of their future performance.
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