Index Funds Vs Mutual Funds
Each type of investment scheme has its own risk, investment objective, expenses as well as fund management styles. While some people may prefer to buy the stocks of their preferred companies, others may prefer to trust experienced fund managers for the same. Thus, the popularity of mutual funds with years of fund management experience under its wraps.
So, when it comes to investing in mutual fund schemes, you are spoilt for choice. There are a variety of mutual fund schemes and each scheme caters to a particular investment strategy.
Mutual funds can be managed actively or passively, and there is quite some difference between the two. Passive mutual fund schemes are called Index Funds.
So, what is the difference between Index Funds and Mutual Funds and which is better for whom?
What are Mutual Funds?
An investment that is done by the fund managers on behalf of the investors based on the investment strategy of the scheme so as to generate an alpha against the underlying benchmarked index is called Mutual Funds.
While equity funds promise high returns, they carry high risks too. Debt funds, on the other hand, are less risky and their returns are also comparatively low. Balanced funds are a mix of the two. Thus, the type of fund needs to be chosen as per one’s risk appetite and asset allocation.
What are Index Funds?
Index funds are diversified equity funds which invest in the stocks of a particular underlying benchmarked index with an aim to mirror the performance of that index. So, the fund manager purchases all the stocks that comprise the index and in the same percentage holding and just lets it perform organically, without any fund manager’s interference.
How do they perform?
If the underlying benchmark index, say Sensex or Nifty 50 grows by 12%, the index fund would also give a positive return of 12% and if the index loses points, the returns would also be negative. Thus, there is no alpha that is generated by an index fund against the underlying benchmarked index.
The only difference in return between an Index Fund and its benchmarked index is because of brokerages paid, management cost, etc. which is marginal. So, an Index Fund basically matches the performance of the benchmarked index before the fees are paid.
Similarities between Index Funds and Mutual Funds
Index funds are a type of mutual fund scheme and therefore they have a lot of similarities with other mutual fund schemes. These similarities include the following –
1. Both invest in stocks and securities listed in the capital market
2. Both aim to provide market linked returns
Here the similarities end.
Beyond these points, index funds are completely different from other mutual fund schemes. Let’s understand how –
Difference between Index Funds and Mutual Funds
1. Investment style: Passive V/S Active
Index funds are passively managed funds. This means that in the case of index funds, a particular benchmark index is chosen and the fund is invested in the chosen index. There is minimal or negligible management of the fund portfolio. It remains invested in the index and mirrors the index’s performance. Index funds, therefore, follow the strategy of ‘invest and forget’. As such, the turnover ratio of index funds is low.
Mutual funds, on the contrary, are actively managed funds. The fund managers continuously change the asset allocation of the fund depending on market performance to generate maximum returns. Thus, in the case of mutual fund schemes, asset allocation is dynamic and the turnover ratio is also higher than that of index funds.
2. Portfolio composition: Fixed V/S Variable
The portfolio of index funds comprises of the stocks and securities listed in a particular index which is the benchmark index of the fund. Thus, the portfolio of an Index Fund is “fixed” according to the stocks chosen in the benchmarked index in the same proportion.
In the case of mutual funds, the stocks are selected according to the investment objective of the scheme and the fund manager’s expertise. Thus, the portfolio of a Mutual Fund is “variable” as per the discretion of the fund managers.
3. Objective of the fund:
The objective of index funds is to track and imitate the movement of the benchmark index.
The objective of mutual funds is different. Fund managers of the mutual fund scheme aim to beat the benchmark index so that they can generate an alpha which would give returns better than that of the benchmark index.
4. Expense ratio of the fund: Low V/S High
Index funds are passively managed and so the job of fund managers is negligible. This results in low expenses and the total expense ratio of index funds is very low.
Compared to this, mutual funds have a high expense ratio which is due to the fact that fund managers actively change investment strategies to generate better returns from mutual fund investments. Due to higher participation of fund managers, mutual funds charge a higher fund management fee which increases the total expense ratio of the fund.
5. Type of fund: Fixed V/S Variable
Index Funds are can only be equity funds benchmarked on a particular index.
However, mutual funds can be either debt or equity or balanced, depending on the type of scheme selected.
6. Investment Risk: Low V/S High
The overall risk of investment in Index Funds is comparatively lower than regular Mutual Funds as the fund managers have their exposure ONLY in the same funds as the index.
However, in the case of Mutual Funds, the risk depends on the type of mutual fund selected:
• Liquid, Cash, Debt and Balanced Funds are lower in risk that equity ones
• Diversified Equity Funds, Sectoral Funds, ELSS, etc. are riskier that Index Funds.
Which one is better?
Choosing between index funds and mutual funds depends on your investment strategy, market dynamics and the knowledge that you have of the capital market as a whole.
Index funds are better if –
• You are a beginner and are unaware of the stocks which could give you good returns
• You need a low expense ratio for your investment portfolio
• You need a positive yet stable rate of growth in your investment portfolio
• You want to invest in particular stocks of an index in a diversified manner
• You don’t want to track your investments continuously and are happy with a passive investment strategy
• For large institutions with a surplus in funds and wishes to participate in equity investments without too much risk.
On the other hand, other mutual funds are suitable if –
• You want to generate alpha on your investment portfolio
• You do not mind the higher expense ratio as you can expect better returns than the returns of the benchmark index
• You need more control on your Asset Allocation and thus choose funds freely without having to restrict yourself to passive fund management.
So, you have to first understand your investment strategy to choose the most ideal fund for investing your hard-earned money. But you should know the concept of index funds and the differences between such funds and other mutual funds to make an informed choice.