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Index Funds Vs Mutual Funds: 5 Major Differences

Individuals still facing a dilemma with index funds vs mutual funds investment must know that their choice should align with their financial standing and goals

August 17, 2021 / 01:35 PM IST

Investments in mutual funds are relatively easier than directly buying stocks. They are more diversified, cushion the risks, and require less active monitoring of share price movements.

But that’s a generic understanding of it and, honestly, not sufficient. As you decide to invest in mutual funds, you will be faced with a buffet of choices. Picking a suitable scheme from these requires more layered knowledge.

However, before moving on to their nuanced distinctions, you must be familiar with the broader types of MFs - active and passive schemes.

While the former might have prospects for greater returns, the latter offers reduced risk. Index funds are an example of passively managed MFs. The primary distinctions of index funds vs mutual funds lie in their investment objective, cost, and management style.

Now the question is: how do you make a choice between index funds and mutual funds? By analysing their differences in the context of your financial goals, risk appetite, the extent of involvement, etc.

Let’s dive in.

5 Top Differences Between Index Funds and Mutual Funds

1. Investment and management style

The primary difference between index funds and other mutual funds is fund allocation and management. Actively managed MFs require fund managers to decide the combination of assets and the proportion of investment. Therefore, the fate of these funds depends heavily on the experience, bias, and skill set of a fund manager.

On the other hand, index funds are passively managed. These funds track popular benchmarks like Nifty 50 and invest in the exact same units in identical proportions. This way, these funds take their underlying benchmark as a wireframe for investment and tend to replicate its properties. Index funds, hence, offer a more hands-off investment approach.

2. Expense ratio

Probably the most prominent difference between index funds vs mutual funds, from an investor’s perspective, lies in their operating costs. The annual cost of managing the operation of these funds is called the expense ratio. This is expressed as a percentage of the AUM (assets under management) of a scheme.

As already discussed, fund managers have to constantly perform extensive industry research in actively managed mutual funds. Thereafter, they choose the securities to mobilise available assets. This is why the expenses of such funds are sufficiently high.

Since index funds are passively managed, they require negligible involvement of a fund manager. As a result, these funds feature affordable expense ratios. However, these charges vary across fund houses.

3. Performance

The mutual funds vs index funds performance comparison will illustrate a steep contrast between the two under different market conditions.

Actively managed mutual funds, especially equity-oriented ones, aim to outperform the current market benchmarks. This is the goal, based on which fund managers mix and match holdings. During a market decline across different sectors, these funds beat the market performance and offer higher returns. However, that is not the case most of the time.

Index funds hold a record of outperforming actively managed funds more than 80% of the time. This is because the former tries to emulate high performing benchmarks like Nifty 50. They tend to replicate their underlying index’s performance instead of beating them. In a bearish market, there is little chance of index funds offering poorer returns than active funds.

This is why most investors prefer keeping a mix of active and passive mutual funds. That way, better returns from one can compensate for the loss suffered from another.

4. Simplicity

An Investor while choosing an Active Fund has to do extensive research before selecting a fund. Past returns, fund manager’s historical return, Total AUM, etc need to be considered before investing.

On the other hand, index funds that track the same index usually have similar returns. It’s simple to understand and the decision mostly comes down to expense ratio and tracking error.

5. Risk

No mutual fund investment can guarantee zero risks. An index fund is also a type of mutual fund and, hence, market volatility plays an important role here. One of the differences observed when comparing index funds vs mutual funds is the type of risk.

In the case of actively managed mutual funds, the risk heavily depends on the market capitalisation of the holdings. Large-cap funds, for instance, are known to offer stable returns against low volatility. A more aggressive investment strategy involves medium and small-cap funds. These funds invest in units with a sizeable growth scope, thereby offering higher returns. At the same time, they are way more volatile than large-cap ones and can lead to serious losses amidst a failing market.

The risk in index funds depends on the underlying index. For example, the Nifty 50 index is less volatile than Nifty Next 50 index. Index funds are pretty well diversified across sectors so volatility is reduced considerably.

Tracking error might also be a cause for lower returns for investors.

Bottom line

Individuals still facing a dilemma with index funds vs mutual funds investment must know that their choice should align with their financial standing and goals. While index funds have a history of outperforming active funds, there are highly efficient active fund managers as well. However, for new investors who have just begun exploring MF investments can consider investing in index funds.

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first published: Aug 17, 2021 10:41 am