Mutual Funds vs. Index Funds

6 mins read

In today’s market, investors get many options to invest in various market instruments. While they can invest in stocks directly, they are also provided with more accessible options such as mutual funds and index funds. Knowledge of these instruments is crucial to make your invest your money, and it is easy to get confused between these various funds so let’s look into it step by step.

What is a Mutual Fund?

A mutual fund is an instrument that takes money from many investors to create a pool of money that it invests into a portfolio of securities such as bonds, stocks, etc., to earn returns. This portfolio of securities is made in a structured format to achieve specific return objectives of the mutual fund. Whenever one invests in a mutual fund, they don’t trade shares of the company in which the mutual fund invests. Instead, they invest in the mutual fund, a company in itself.

Active and Passive Mutual fund

While there are different types of mutual funds, they can be divided into active and passive mutual funds. For active mutual funds, the fund manager has to conduct a lot of industry research and build the portfolio accordingly based on the market performance of various securities. Whereas passive mutual funds allow a lower involvement level of the fund manager as the stocks don’t have to be chosen actively. Index funds are an excellent example of passive funds.

What is an Index Fund?

Index funds portfolio is linked to a financial market index. It comprises stocks or bonds that imitate a market index such as Nifty 50, BSE Sensex, S&P 500, etc. Index funds consistently follow their benchmark stock market index irrespective of the ups and downs in the market.

As an investor, just the basics are not often enough. It is imperative to understand the many nuances of Mutual Funds vs. Index Funds to pick a suitable scheme for investing. Let’s deep dive into the differences between the two:

Management style and type of investment

Mutual funds managers are stock pickers. They actively choose stocks and assets to build the mutual fund portfolio based on their rich experience and skills as a fund manager. It also assures the investor that their mutual fund is managed by professionals actively seeking the best possible return for them.

On the other hand, index funds follow the passive investment strategy approach based on one particular benchmark index. The manager of this fund has a specific fixed set of stocks involved in the portfolio, which eliminates the activity of choosing stocks, providing a more uncomplicated management style.

Investment Objective

While both mutual funds and index funds invest in stocks, bonds, and securities, their objective differs as index funds usually aim to achieve returns equivalent to their benchmark index. In contrast, mutual funds aim to beat the benchmark index in terms of returns.

Risk level

We are aware that mutual funds are subject to market risk, but the level of risk varies for index funds though they are a type of mutual fund.

Mutual fund portfolios can be large-cap, mid-cap, and small-cap, and risk is based on the market capitalization of their stocks. Large-cap funds are more stable than mid-cap and small-cap, which tend to follow a more aggressive strategy. High volatility also comes with high returns and sizable growth; however, it leads to heavy losses if the market falls.

Index funds are subject to the market volatility of the underlying index. For example, if BSE Sensex is less volatile than the Nifty 50 index. Since the companies involved in an Index fund are spread well across various sectors, the market volatility is widely spread, making index funds less risky by their fundamental nature.

The difference in the expense ratio

Running a mutual fund costs more money than running a passive index fund. The fund managers of a mutual fund are consistently managing the fund by doing extensive research to choose the stocks that might beat the stock market and provide good returns to their investors. At the same time, the fund manager also charges fees, salaries, bonuses, and there is a further expense in terms of office space, marketing, and operational costs.

This overall makes the annual cost of managing a mutual fund known as the expense ratio. The ratio that is a percentage of the assets under management (AUM) of the mutual fund scheme is called the expense ratio.

In the case of the index fund, the expense ratio is comparatively affordable. The cost of managing the fund is lower since lesser research is required, and a lesser amount is the cost to the fund before the investors get the final returns.

The charges may vary according to different mutual fund houses.

Performance and yield of the fund

The actual performance of a mutual or index fund depends on the way it is managed. The fund manager for an actively managed mutual fund consistently curates the holdings according to what he assesses would gain higher than index returns. It depends on the fund manager if he can read the market situation. Many high-yielding mutual funds show excellent performance and do well, but some struggle to do well too.

Index funds are usually cheaper due to low management costs, which can help the investors gain good returns. They may not perform too well in certain market conditions that are very good as they are less reactive. However, in the opposite scenario, they help to get good returns.

Composition of fund and selection

Before investing in an active mutual fund, an investor has to thoroughly research the total AUM of the fund, past returns, and historical returns of the fund manager to select the fund of their choice.

For index funds, investors need to decide based on the expense ratio of the fund and tracking errors as the same index-tracking funds have similar returns.

In conclusion

You saw the difference between mutual funds and index funds that helped you gain further insight into the layers of these instruments. However, investors must thoroughly understand the particular schemes they are investing in before investing. An investor should highly consider the costs associated with a mutual fund to realise the final return on the risk taken. Considering the financial goals and time at hand is necessary before choosing between mutual funds vs. index funds to create a suitable investment strategy.