Index Funds vs Mutual Funds

Many mutual funds are actively managed by investment professionals and index funds are passively-managed. Explore key differences between index funds and mutual funds.
Index Funds vs Mutual Funds
4 mins
09-June-2024

Numerous mutual funds are overseen by investment experts striving to surpass market benchmarks. Conversely, index funds operate passively, aiming to closely mirror the performance of their designated index.

Investing in the financial markets offers a wide array of opportunities for wealth creation. In this comprehensive guide, we will delve into the key distinctions between Index Funds and Mutual Funds, enabling you to make informed investment decisions.

Active vs. Passive Management

Mutual funds can be managed actively or passively:

Active management

In actively managed mutual funds, investment professionals or a team of portfolio managers actively select investments for the fund aiming to outperform a stock market benchmark. These funds typically come with higher associated fees.

Passive management

Passively managed mutual funds replicate the performance of market indices. This is generally achieved through automated or mostly hands-off systems, resulting in lower management costs and fees. Common goals for mutual fund investors include retirement savings, as mutual funds offer broad diversification, as well as saving for emergencies or a child’s college education.

What is an index fund?

An index fund is a type of mutual fund designed to replicate the performance of a specific stock market index. These funds are also known as "passive funds" or "tracker funds" because they aim to mimic the returns of an underlying benchmark index rather than actively picking individual stocks. The concept behind index funds is to provide investors with a simple, cost-effective, and low-risk way to invest in the stock market while diversifying their portfolios.

Read more about: What are index funds?

What is a mutual fund?

Mutual funds are a popular investment vehicle in the Indian financial market that pools money from numerous investors to invest in a diversified portfolio of stocks, bonds, money market instruments, or other securities. They are managed by Asset Management Companies (AMCs) and offer a way for individuals to participate in the financial markets without directly buying and managing individual securities. Read more about, what is a mutual fund?

Differences between index funds and mutual funds

1. Investment and management style

Index funds and mutual funds diverge in their investment and management approaches, impacting performance and costs.

Index funds suit those favoring a passive strategy, requiring minimal intervention from fund managers. They offer cost-effectiveness with lower fees, tracking specific market indices for diversified portfolios, appealing to risk-averse investors.

Conversely, mutual funds entail active management, where managers select securities to outperform the market. This hands-on approach incurs higher expenses, attracting risk-tolerant investors seeking potential higher returns.

2. Expense ratio

When comparing index funds to mutual funds, the expense ratio is crucial. Index funds boast lower expense ratios due to their passive nature, resulting in cost savings and enhanced returns for investors. Conversely, actively managed mutual funds carry higher expenses stemming from intensive management, potentially diminishing returns despite potential outperformance.

3. Performance

Index funds closely mimic market performance, delivering steady long-term returns due to their passive strategy and lower expenses. Conversely, mutual funds aim to outperform by actively selecting securities, potentially yielding higher returns but also risk underperformance. While mutual funds offer potential for outperformance, index funds historically outshine due to lower costs and passive strategy.

4. Simplicity

Index funds offer simplicity with their straightforward passive approach, mirroring specific market indices. Investors find ease in understanding holdings and performance, requiring minimal monitoring. Mutual funds, however, entail complexity with active management, leading to higher expenses and greater tax implications, demanding thorough research and analysis from investors.

5. Risk

Index funds generally carry lower risk, thanks to diversified portfolios that mitigate individual security impact. In contrast, mutual funds may concentrate risk in specific securities or sectors, potentially leading to underperformance despite active management. Both entail risk, requiring investors to align choices with their risk tolerance and investment objectives.

Index funds vs Mutual funds - A comparison table

Mutual Funds offer diversification by spreading investments across multiple stocks. While all types of mutual funds possess the flexibility to select investment options aimed at achieving returns aligned with their stated investment objectives, Index Funds simply track a predefined index. Delve into the fundamental distinctions between index funds and mutual funds below:

Aspect

Index Funds

Actively Managed Mutual Funds

Management Style

Passive Management: They aim to replicate the performance of a specific market index.

Active Management: Fund managers make investment decisions to achieve the fund's objectives.

Objective

To match the returns of a particular index.

To outperform benchmarks or deliver specific outcomes.

Expense Ratio

Generally lower, due to passive management.

Often higher, as active management involves higher expenses.

Diversification

Provides diversification within the index being tracked.

Offers diversification across a broader range of securities.

 

Top Features of Index Funds

  1. Passive Management: Index Funds follow a passive investment strategy, aiming to mirror the performance of a specific index without frequent buying and selling.
  2. Diversification: These funds offer instant diversification by holding a large number of securities within the chosen index.
  3. Lower Costs: Due to their passive management style, Index Funds typically have lower expense ratios compared to actively managed funds.
  4. Transparent: The portfolio holdings of an Index Fund are typically disclosed on a regular basis, providing transparency to investors.
  5. Long-Term Investment: Index Funds are suitable for long-term investors who seek to benefit from the overall growth of the market.

Frequently asked questions

Which is better, index funds or mutual funds?

Index funds offer simplicity and lower costs, tracking market returns closely. Mutual funds aim to surpass market returns but come with higher fees and increased risk.

Is it good to invest in index funds?

Absolutely, especially for long-term investors seeking low-maintenance options. Index funds provide broad market exposure at minimal cost, ideal for those who prefer a hands-off approach.

Why choose index funds over mutual funds?

Opting for index funds brings several advantages, including lower fees, diversification, and a consistent record of matching or even outperforming actively managed mutual funds over time.

What is the return rate of index funds?

Index funds aim to mirror the performance of the market index they track. While this can vary, historical data shows that stock market indexes generally deliver positive long-term returns.

Do mutual funds beat index funds?

Although actively managed mutual funds strive to outperform the market, the majority tend to underperform after factoring in fees.

Are index funds less risky than mutual funds?

While not inherently less risky overall, index funds eliminate the risk of underperforming due to manager selection, a common pitfall with actively managed mutual funds.

How do I choose between an index fund and a mutual fund?

Consider your investment objectives, risk tolerance, and desired level of involvement in managing your investments. Index funds are suitable for low-cost, hands-off investing, while mutual funds offer potential for higher returns with increased risk and fees.

How are the fees for index funds and mutual funds different?

Index funds typically have lower fees, known as expense ratios, because they are passively managed. In contrast, mutual funds, especially actively managed ones, often incur higher fees due to the intensive management involved.

Is the Nifty 50 index fund safe?

"Safe" is relative. Index funds are less volatile than individual stocks, but market fluctuations can still cause losses. However, they offer diversification across the top 50 Indian companies, mitigating some risk.

Is my money safe in index funds?

Index funds are generally considered safer than individual stock picking due to diversification. However, all investments carry some level of risk. A long-term investment horizon helps weather market ups and downs.

What is the ROI of an index fund?

ROI (Return on Investment) in index funds depends on market performance. Historically, they track the market's average return, minus fees.

How to select index funds?

Consider factors like expense ratio, fund performance, and your investment goals. Research different options and consult a financial advisor for personalized guidance.

Can I exit from an index fund anytime?

Yes, typically. Unlike fixed deposits, index funds are open-ended, allowing you to redeem your units on any business day (exit fees may apply).

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Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.