Mutual Funds vs Index Funds: Compare and Invest!
Owing to its low-risk nature, portfolio diversification, and potential for higher returns, mutual funds have become a sought-after investment option in recent times. However, when you proceed to invest in mutual funds, you will find a pool of options to choose from, which can easily confuse you. Picking a suitable scheme among the many can be significantly overwhelming.
Thus, before moving, you need to know the basic distinctions between active and passive mutual funds. While active funds provide a probability of better returns, index funds are known for their less-risky nature.
To help you make an informed decision between these two options, here are a few crucial points.
Top Differences Between Index Funds and Mutual Funds
Here are a few points of difference between mutual funds and index funds that might help you:
1. Investment Style
The primary distinction between index funds and mutual funds is the asset allocation and management style. Actively managed mutual funds depend on fund managers to determine asset allocation and investment proportions. As a result, the returns of these funds rely heavily on the experience, bias, and skill set of a fund manager.
Index funds, on the other hand, feature passive management. These funds invest in the same units in proportions as popular benchmarks such as the Nifty 50. As a result, these funds use their underlying benchmark as a guideline for investment and tend to replicate its characteristics. In this regard, index fund investments provide a more hands-on approach to investing.
2. Expense Ratio
Expense ratio is the most talked-about distinction between mutual funds and index funds. Expense ratio is the annual cost of managing the operation of these funds. This is expressed as a percentage of a scheme's AUM.
As mentioned earlier, fund managers in actively managed mutual funds must constantly conduct extensive industry research. Following that, they select securities to mobilise available assets. This is why such expenses are sufficiently high in these funds.
Because index funds feature passive management, they require little involvement from a fund manager. As a result, these funds have low expense ratios. These fees, however, differ from one fund house to another.
3. Fund Performance
Actively managed mutual funds, particularly equity-oriented funds, seek to outperform market benchmarks. This is a goal that fund managers use to mix and match holdings. During a market decline in various sectors, these funds outperform the market and provide higher returns. However, this is not the case most of the time.
Index funds successfully outperform actively managed funds over 80% of the time. This is due to the former's attempt to replicate high-performing benchmarks, such as the Nifty 50. Instead of outperforming their underlying index, they tend to replicate it. As a result, in a bear market, index funds are unlikely to outperform active funds in terms of returns.
This is also the reason why most investors prefer to maintain a mix of active and passive mutual funds.
4. Ease of Investing
Before selecting an Active Fund, an investor must conduct extensive research. In this regard, you may have to consider past returns, fund manager historical returns, Total AUM, and so on.
Index funds that track the same index, on the other hand, typically have similar returns. It's straightforward, and the decision primarily depends on expense ratio and tracking error.
5. Risks
There is no mutual fund that offers returns without some amount of risk. The risk of actively managed mutual funds is heavily influenced by the market capitalisation of the holdings. The underlying index determines the risk of index funds. The Nifty 50 index, for example, is less volatile than the Nifty Next 50 index. Since the best index funds in India feature a broad diversification across industries, volatility is significantly low.
Now that you know about the key points of difference between index funds and mutual funds, you can start your investment journey in an informed manner.