Have you ever come across the terms mutual funds and index funds? If yes, chances are that you might have initially confused them to be the same. However, these are two distinct terms with different meanings. Index funds are a kind of mutual fund investment that mirror the chosen market index, whereas mutual funds are a broad investment class that follows a wide range of investment strategies.
Before exploring either of these investment categories, investors must know the differences and similarities between the two. This will significantly help in making informed investment choices.
What is a Mutual Fund?
A mutual fund investment pools money from investors and allocates it to a wide variety of securities, including stocks, bonds, etc. These are actively managed investments and involve fund managers who pick investments on behalf of investors. They also charge a fee for their services.
Mutual funds could diversify their investment allocation between stocks, bonds, and other securities or there could be mutual funds concentrated on a single category of an asset like large-cap funds, etc. This strategy makes them less risky as compared to the concentration of investment in a single stock or bond. Mutual fund units are the shares in a mutual fund and are sold at net asset value / NAV per share.
Key characteristics of mutual funds
Here are the key characteristics of a mutual fund investment:
- Mutual fund investments are preferred by investors since they are actively managed by fund managers. This way, investors get an exposure to a portfolio that is expert managed.
- The aim of every mutual fund manager is to ensure optimum returns from investment in securities, keeping the fund’s objectives at the centre of all decision-making.
- Investors receive fund units depending on their contribution to the total investment or pool. Each investor makes either profits or losses directly proportional to the amount of investment.
- Mutual fund performance heavily depends on the performance of underlying assets.
Pros & Cons of mutual funds
Pros of Mutual Funds:
- Diversification: Mutual funds invest in a wide range of securities, which reduces the risk of loss. This means that by investing in a mutual fund, you can easily diversify your investment portfolio and reduce your overall risk.
- Professional Management: Mutual funds are managed by professional fund managers who have the expertise to analyze and evaluate investments. They can make informed decisions on behalf of investors, saving them time and effort.
- Liquidity: Mutual funds are highly liquid, meaning that investors can buy and sell their shares at any time. This makes them a convenient investment option for those who may need to access their funds quickly.
- Accessibility: Mutual funds are easily accessible to all types of investors, regardless of their level of investment knowledge or experience. They have low minimum investment requirements, and investors can choose from a range of funds that cater to different investment objectives and risk levels.
Cons of Mutual Funds:
- Fees: Mutual funds charge fees, including management fees, transaction fees, and other expenses. These fees can eat into your returns, and in some cases, can be relatively high.
- Lack of control: When you invest in a mutual fund, you are entrusting the fund manager with your investment decisions. This means that you do not have control over individual investments made by the fund.
- Tax implications: Mutual funds can have tax implications, which can be complex and difficult to understand. Investors may be subject to capital gains taxes on profits earned by the fund, even if they did not sell their shares.
- Market risk: Mutual funds are subject to market risk, which means that their value can fluctuate based on market conditions. This can lead to losses, and investors may not always be able to predict these fluctuations.
What is an Index Fund?
An Index fund is a type of mutual fund that mirrors its portfolio to the chosen index. It is also referred to as ‘index-tracked’ mutual funds. Index funds are new to the Indian investment market, and very few investors are aware of this investment type. It is slowly picking pace as more investors see the benefits of generating returns by following an Index.
Key Characteristics of Index funds
The key features of an Index fund are as below:
- Index funds exactly follow the stock composition of an Indice and do not allow room for customisation.
- These are not actively managed, as the idea is to follow an index at all times. Thus, they have a minimal expense ratio.
- While index funds intend to follow and mimic an index at all times, there is a scope of tracking error. Tracking error occurs when there is a difference between the fund performance vs the performance of the index it follows.
Pros & Cons of Index funds
Pros of Index Funds:
- Low fees: Index funds are passively managed, meaning they do not require the same level of active management as other types of funds. This typically results in lower fees compared to actively managed funds.
- Diversification: Index funds invest in a broad range of securities, which reduces the risk of loss. This means that by investing in an index fund, you can easily diversify your investment portfolio and reduce your overall risk.
- Consistent performance: Index funds are designed to track a specific market index, such as the S&P 500. This means that their performance tends to be more consistent and predictable over the long-term.
- Accessibility: Index funds are easily accessible to all types of investors, regardless of their level of investment knowledge or experience. They have low minimum investment requirements, and investors can choose from a range of funds that cater to different investment objectives and risk levels.
Cons of Index Funds:
- Limited flexibility: Index funds are designed to track a specific market index, which means that they are limited in terms of their investment options. They cannot deviate from the index they are tracking, even if there are potentially better investment opportunities elsewhere.
- No active management: Unlike actively managed funds, index funds do not have a fund manager making investment decisions on behalf of investors. This means that investors do not have the benefit of professional investment expertise.
- Market risk: Index funds are subject to market risk, which means that their value can fluctuate based on market conditions. This can lead to losses, and investors may not always be able to predict these fluctuations.
- Tracking error: Index funds aim to track a specific market index, but there can be slight deviations from the index due to factors such as fees, expenses, and trading costs. This is known as tracking error and can impact the fund’s performance compared to the index it is tracking.
5 Major Difference between Index Funds and Mutual Funds
Three key factors differentiate index funds from mutual funds. These are the management style, aim of the fund, and the cost involved in each. Here, we have presented a brief version of these differences along with other points that will help you differentiate between the two forms of investments.
|Differences||Index Funds||Mutual Funds|
|Objective||To invest in securities that are part of an index and mirror the returns generated by the index followed.||To invest in various securities by pooling money from investors. The main objective is to maximise investor returns at any given time.|
|Management Style||Passively Managed. Does not require picking of stocks by fund manager.||Actively Managed. Choice of investment in stocks and bonds is at the discretion of the fund manager.|
|Cost||Lower expense ratio and hence, less cost. This is because of lower management fees.||Higher expense ratio as higher fund management fees is involved.|
|Investment Type||Invests in stocks, bonds, etc depending on composition of the index it follows.||Invests in stocks, bonds, and other securities as per the fund manager’s decisions and investment objective of the mutual fund.|
|Flexibility||Has lower flexibility since it has to restrict investment as per Index followed.||Offers higher flexibility as fund managers can switch between securities depending upon their expected performance.|
Where to Invest – Index Fund or Mutual Fund?
Both mutual funds and index funds are ideal investment choices for investors who don’t want to take the risk of trading by themselves.
If you are looking for some flexibility in asset movement, then mutual funds may be the right investment option for you. Mutual funds aim to beat benchmark indexes and can therefore result in far higher returns than the indices. These also allow short-term capitalisation of gains because of active fund management strategies.
Index funds are best for individuals who do not prefer the risk involved in actively managed equity funds. While investing in index funds, it is recommended to remain invested for a long term of at least 5 years to see positive returns. With index funds, however, it is not possible to beat the index returns since the aim of these funds is to replicate the index returns.
Index funds or mutual funds, the returns of both these investment options are based on the market, so you should be aware of this fact and take investment decisions based on your risk profile, required amount and the investment time horizon.
Frequently Asked Questions
- Do index funds outperform mutual funds?
Index funds aim to match returns of the Index they follow. Active mutual funds, on the other hand, aim to outperform the indices. The performance of an index fund is often predictable, whereas a mutual fund performance is less predictable and depends on the investment choices made by the fund manager.
- Do index funds charge any fees?
Index funds involve a certain percentage of fees, however, these are far lower as compared to mutual funds since Index funds are not actively managed.
- Are index funds a good investment choice?
Index funds are ideal for risk-averse investors who aim to generate returns in the long run by following the performance of an Index.
- How can I invest in an Index fund?
To invest in an index fund, you can use the Fisdom app and follow easy registration steps to begin your investment process. This is a free app with expert tips on fund selection based on your risk profile.