Index Funds Vs. Mutual Funds: Major Differences (2024)

Mutual funds and index funds are popular options for diversifying your portfolio without having to hand-pick individual stocks. Both allow you to spread your investments across various assets and industries, decreasing your level of risk. Although these investment options are similar, investors should understand there are several key differences between them before investing their hard-earned money.

What Is a Mutual Fund?

In the Indian context, mutual funds are meticulously managed investment vehicles that pool funds from numerous investors. When an individual acquires a share of a mutual fund, they essentially obtain a portion of ownership in the fund, entitling them to a proportionate allocation of the income and capital gains generated by the fund.

The fund’s dedicated investment manager is responsible for deploying the fund’s assets across a diverse array of assets, including stocks, bonds, and other securities. These professionals make crucial decisions regarding what assets to purchase, sell, and trade on behalf of the fund’s shareholders, aiming to optimize returns and manage risks effectively within the Indian investment landscape.

Active vs. Passive Management

Mutual funds can be actively or passively managed:

Actively-managed mutual funds: In an actively-managed mutual fund, an investment professional or team of portfolio managers selects the investments for the fund with the goal of outperforming a stock market benchmark. Actively managed funds typically have higher fees associated with them.

Passively-managed mutual funds: Passively-managed mutual funds mimic the performance of market indices. Generally through automated or mostly hands-off systems that cost less to manage, resulting in lower fees. For those who own shares of mutual funds, retirement is the most common goal. Mutual funds are a good fit for retirement savings because they provide broad diversification. Other common goals for mutual fund investors include saving for emergencies or a child’s college education.

What Is an Index Fund?

In the Indian context, an index fund is not a distinct investment vehicle but rather a type of passively-managed mutual fund designed to closely track the performance of specific market indices, such as the Nifty 50 or the Sensex. Index funds in India function by replicating the holdings and weightings of securities within the chosen index, aiming to match the benchmark index’s performance as closely as possible.

These funds may include all of the holdings within the index or a representative sample of them. The key objective of index funds is to mirror the returns and movements of the underlying index. Index funds are a preferred choice for many Indian investors, particularly those with a long-term, passive investment strategy, due to their lower costs and consistent performance tracking of market benchmarks.

Distinguishing Features:

While both index funds and mutual funds provide portfolio diversification, significant distinctions should be considered:

Objectives: The fund’s objectives dictate how the portfolio is managed and what investments are included. Many mutual funds are actively managed by investment professionals with the goal of outperforming market benchmarks. By contrast, index funds are passively-managed and designed to match their index’s performance as closely as possible.

Costs: In India, index funds are known for their cost-effectiveness, primarily because they follow a passive investment approach. The total expense ratio (TER) for index funds in India typically falls within the range of 0.20% to 0.50%. In contrast, actively managed funds often come with higher TERs, ranging from 1% to 2%.

The reason behind the lower costs of index funds lies in their passive management strategy. These funds do not require intensive decision-making by fund managers to select individual securities for buying and selling. Instead, they aim to replicate the performance of a specific market index, such as the Nifty 50 or the Sensex.

It’s essential to note that while index funds offer cost advantages, they are not entirely free to own. Even if an index fund has a 0% expense ratio, investors may still incur expenses related to the purchase of fund units and potential tax implications. Therefore, while index funds offer a cost-efficient way to invest in a diversified portfolio, investors should consider all associated costs when making investment decisions.

Flexibility: Mutual funds are more flexible than index funds because the investment professional managing the fund can respond to market changes and change the fund’s holdings. With an index fund, the fund only invests in securities within a specific index.

Risks: Actively-managed mutual funds can be riskier investment options than index funds. With a portfolio manager trying to outperform the market, there’s a chance they will make poor decisions that hurt the fund’s performance.

Which is Better, Active or Passive Funds?

In the Indian context, the distinction between index funds and mutual funds primarily revolves around fund management. Active management, a key feature of mutual funds, may appear enticing as it seeks to surpass market benchmarks. However, it’s crucial to consider that even the most seasoned investment professionals often find it challenging to consistently outperform market indices.

When examining your investment choices, it’s important to keep in mind that while some investment experts occasionally achieve superior results, their performance tends to be inconsistent. S&P Dow Jones Indices’ scorecard, which evaluates the performance of actively-managed mutual funds against major indices, provides valuable insights. Over a one-year period, it revealed that 51.08% of actively-managed mutual funds in India underperformed the S&P 500, while 48.92% outperformed it. These statistics, however, undergo significant changes over longer time frames.

Over five years, only 13.49% of actively-managed funds managed to outperform the S&P 500, and over a decade, a mere 8.59% achieved this feat. Therefore, depending on your investment objectives, opting for low-cost index funds can be a prudent choice, given that the majority consistently deliver better results than actively-managed mutual funds in the Indian market.

Investing for the Future

Mutual funds and index funds are popular investment options for those looking to diversify their portfolios. They both allow you to invest in many securities and industries at once, and due to their relatively low costs, they can be affordable for a wide range of investors. Before you decide between index funds vs. mutual funds, consider your investment goals and risk tolerance. Index funds tend to be low-cost, passive options that are well-suited for hands-off, long-term investors.

Actively-managed mutual funds can be riskier and more expensive, but they have the potential for higher returns over time. You can use investing analysis tools like Morningstar or Forbes to view detailed information on the performance and fees of different funds so you can make an informed decision. If you aren’t sure which fund type is best for you—or if you simply want a checkup to ensure you’re on track to meet your goals—meet with a financial advisor to review your finances and develop an investment plan.