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Index funds are a type of mutual fund that mimics the benchmark index. They aim to give market returns at lower costs. Mutual funds are both actively and passively managed. Fund managers perform extensive research to decide on the portfolio that will have the capability to deliver superior returns than the market. However, they come with additional costs and higher risk than index funds. Read the article to understand index funds, mutual funds and index funds vs mutual funds in detail.

What are Index Funds?

An Index Fund is a mutual fund that replicates the benchmark index. For example, Nifty is a benchmark to many mutual funds that aim to generate equal or higher returns than Nifty. While an Index fund replicates the composition of Nifty and aims to generate similar returns and not more. Therefore, index funds are passively managed funds. Also, these funds have a low portfolio turnover, broad market exposure, and low expense ratio in comparison to other actively managed funds. Index funds are suitable for long term investors who do not have the time to constantly monitor their investment portfolio.

How does an Index Fund Work?

Index funds replicate a specific index or benchmark. Stocks from the same sector are grouped together to form an index. As a result, an index defines a market sector or segment. The segments can be either equity-oriented instruments such as stocks or debt-oriented instruments such as bonds. For example, an index fund replicating Nifty will own the same 50 equity shares as of Nifty and in the same proportion.

Since index funds merely replicate a benchmark index, they are passive funds. The fund managers simply follow the benchmark composition and don’t choose stocks at their own discretion. The fund management team consistently strives to maintain the same composition as the underlying benchmark.

Index funds aim to mimic the benchmark index and generate more or less equal returns as the benchmark. However, there is often a small variation in the performance, and this is the tracking error. A fund with the least tracking error is referred to as the best fund. In comparison to actively managed funds, these funds have a low expense ratio. Furthermore, all future inflows will be invested in the same proportion as that of the underlying index.

There are two forms of index mutual funds in India: index mutual funds and index exchange traded funds. Similar to other mutual funds, index funds are offered directly by the mutual fund house. On the other hand, the Index Exchange Traded Funds are traded on the stock exchange.

What are Mutual Funds?

A mutual fund is a type of investment instrument that pools money from several investors and invests it in the stock market. Mutual funds invest in a variety of assets, including stocks, bonds, and other financial instruments. Mutual funds can be either actively managed funds or passively managed funds.

Actively managed funds invest as per the fund’s objective. The fund manager constantly performs research and identifies the best stocks that align with the fund’s objective. On the other hand, passively managed funds simply replicate a benchmark or index.

The investment objective of a fund determines the type of assets that it invests in. For example, if a fund’s objective is to generate stable long term wealth, then it would strategically invest in stocks of large and stable companies. These companies tend to offer stable returns year after year.

Mutual funds are professionally managed investments. There are different types of mutual funds. In general, they can be classified based on the assets they invest in. The three categories of mutual funds based on asset class are equity funds, debt funds, and hybrid funds. Mutual funds may also be categorised into several other types based on their investment options, structure, and strategy.

Mutual funds are excellent investment options that offer good diversification to investors. There are numerous mutual funds in the market that cater to the different needs of the investor. Depending on the investment horizon, financial goals, income levels, one can choose a suitable fund for investment.

Mutual funds are volatile investments and therefore are subject to market volatility. Returns (capital gains) from mutual funds are subject to taxation based on their holding period and type of fund.

Index Funds vs Mutual Funds – How to Choose?

Though both index funds and mutual funds are considered mutual funds, they are very different. Index funds and mutual funds differ in terms of their portfolio, management style, costs, and objectives.

Portfolio

Index funds invest in a specific set of securities like the stocks on a particular index or benchmark. On the other hand, mutual funds invest in stocks and other securities that the fund manager chooses. The stocks may or may not be a part of a particular index. However, they are chosen by the portfolio manager based on the fund’s objective.

Management Style

Index funds are passively managed funds. The portfolio managers do not actively participate in choosing the securities for the fund’s portfolio. Mutual funds, on the other hand, are both actively and passively managed. The fund managers play an active role in picking securities for the portfolio.

Costs

Index funds are less costly when compared to mutual funds. The expense ratio for index funds is lower and ranges between 0-2%. Whereas the expense ratio is higher for mutual funds than index funds and can go up to 2.5%.

Objectives

Index funds aim at delivering market returns by mimicking the benchmark portfolio. On the other hand, mutual funds aim at beating the market returns and delivering superior performance.

The choice between index funds vs mutual funds totally depends on the investor’s needs, requirements, and profile. However, there are certain things to keep in mind before making a choice.

Flexibility

Suppose an investor is looking for better flexibility in terms of the portfolio. In that case, mutual funds are better as they are actively managed. Moreover, the fund manager will be in a position to hedge the portfolio in unfavourable conditions. Also, fund managers can trade in the short term to make short term gains.

Potentially higher returns

Mutual funds have the ability to deliver higher returns than the market in favourable market conditions.

Costs

Index funds are cheaper when compared to mutual funds. Moreover, the taxes on capital gains will be lower when compared to debt funds.

Convenience

Index funds need not be tracked every day. One can invest in an index fund and forget about it until the end of the investment horizon.

Both index and mutual funds have their own pros and cons and offer equal opportunity to create wealth. Investors have to make a choice based on their objectives and requirements. Moreover, their choice should be based on the homework and analysis done.

Actively vs. Passive Management of Funds – Which is Better?

Active management aims to achieve superior returns than the market or benchmark. Whereas passive management mimics the portfolio of the benchmark to achieve similar returns. Both styles of management help in creating wealth however, they differ in terms of the process. Following are few differences between the active and passive management styles:

Returns

Active fund management aims to generate returns higher than the benchmark. However, there is a chance that the returns can be lower than the benchmark. However, in passive fund management, the fund gives benchmark returns with a slight tracking error.

Risk

An actively managed fund’s portfolio can be more or less volatile than the benchmark portfolio. It depends on the fund manager’s objectives. A passively managed fund’s portfolio has a similar risk to that of the benchmark.

Research

An actively managed portfolio requires knowledge and in-depth market research. It requires a thorough analysis of the market, prospective companies, and other economic factors. The fund manager is highly skilled in performing such research. A passively managed portfolio doesn’t require any research as it mimics the benchmark index.

Prompt decision making

Fund managers in active fund management have the discretion to take prompt decisions in case of favorable and unfavorable market conditions. This allows them to hedge the risk or encash a market opportunity. However, in passive fund management, the fund managers do not have such freedom.

Both styles are considered good for investing and creating wealth in the long term. However, an investor has to choose a style based on their goals, objectives, understanding of risk and investment horizon.

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