Investing through mutual funds is a convenient mode to start investing in financial markets. Investing in mutual funds is easier as compared to picking up stocks or bonds individually. Investors do not need to conduct their analysis; they help in diversification, mitigate risks. However, choosing mutual funds across different categories also requires some knowledge regarding these products. The first level of differentiation in mutual funds is active and passive mutual funds.
Active Management v/s Passive Management
All mutual funds have a benchmark to gauge the performance of the fund. For instance, an equity Large Cap fund would have the Nifty 50 as a benchmark, and a Mid Cap fund would have the S&P BSE Midcap Index as the benchmark, and so on.
Active Management means that the fund manager applies his research, skill, and knowledge to select securities. An objective of the active fund manager is to beat the benchmark by a reasonable margin over the long run. The difference between the fund’s return and the benchmark’s return is known as the alpha. The higher the alpha, the higher is the skill of the fund manager.
Passive Management means that the fund manager is responsible for mirroring or replicating the constituents of an index. The fund manager does not have to apply his skill in choosing the constituents of the fund. The objective of a passive fund manager is to replicate the returns of the benchmark and not to outperform it, as in the case of an active manager. An Index Fund is a passively managed mutual fund. Let’s look at the pros and cons of index v/s mutual funds.
What are the pros of investing in an index fund?
1. Lower cost:
Index funds have lower fund management fees as compared to an actively managed mutual fund. The difference in expense ratio may seem small when looked at on a standalone basis. However, when compounded over time, it has a significant impact on the returns of an investor. An active fund may charge up to 2% as an expense, where an index fund expense may be as low as 0.35%.
2. May outperform an active fund manager:
More often than not, active fund managers underperform their passive counterparts in the long run. Even though the fund managers apply their research, they tend to underperform the market because of their own behavioral biases and flaws in judgment. A fund’s strategy may not play out as expected in the short term, leading to underperformance.
Index funds help investors access a niche sector of the market, which may have a lower correlation with the investor’s portfolio. This helps in reducing the risk of the portfolio.
4. Easier to understand:
When investing in an actively managed mutual fund, an investor needs to understand the fund manager’s stock selection philosophy to decide on investing with him. This may not be a very easy task for a layman. Investing in a passively managed fund is easier because the investor would already know about the fund’s constituents. Thus it is easier to understand the strategy of a passively managed fund.
What are the cons of investing in an Index Fund?
1. Lack of downside protection:
An index fund replicates the portfolio of the index. Thus, if the stocks/bonds in the index face headwinds, the fund manager will not have the liberty to change the exposure to those securities.
2. No control over holdings:
A passive fund manager cannot create a portfolio of stocks that he thinks can be better than the index constituents. The fund manager must maintain the same percentage weight and have the same constituents at all times.
Thus to understand the difference between a mutual fund and an index fund, it is essential to note that it is a type of mutual fund. Thus, it would be appropriate to differentiate between an actively managed fund and a passively managed fund, i.e., an index fund. Both of these products help investors to achieve their investment goals through different methods. Index funds allow you to enjoy predictable and steady returns, whereas an actively managed fund may sometimes beat the market returns.
|Particulars||Active Mutual Funds||Index Funds|
|Expense Ratio||Higher expense as compared to Index Funds||Index Funds charge a much lower expense ratio as compared to actively managed funds|
|Strategy||Create a portfolio of stocks after detailed research and application of judgement and skill||Replicate or mirror the portfolio of the underlying index|
|Objective||Outperform the benchmark and create the highest alpha||Match the returns of the benchmark or the underlying index|
|Type of Fund||Open-ended Funds||Close-ended Funds|
Index funds closely track the underlying. This does not make them risk-free. One must take cognizance of their own investment goals and constraints before making a choice. These funds are subject to market risk, also known as a beta risk which cannot be diversified away. Also, index funds may have the risk of tracking errors. Tracking error is the difference between the return of the benchmark and the return of the index fund. Thus, an investor may use a combination of both active and passive management strategies when choosing between mutual funds v/s index funds.