Index fund vs mutual funds: What is the difference

All index funds are mutual funds, but not all mutual funds are index funds. While both offer diversification and the potential for wealth creation, they adopt rather different strategies and approaches, making each of them suitable for specific investment cases. In this article, we’ll understand the differences between index funds and actively managed mutual funds through relatable scenarios, helping you determine which option aligns favourably with your financial goals.

• Table of contents

• Differences between index funds and mutual funds
• Index funds vs mutual funds - Which is suitable
• How to invest in mutual funds, including index fun

Differences between index funds and mutual funds

Here are the differences between index funds and mutual funds on various parameters:

1.Investment and management style

Index funds (passive)

• Operate on a passive investment strategy, tracking the composition of a specific market index, such as Nifty50 or BSE Sensex.
• Fund managers primarily ensure the fund portfolio mirrors the index, potentially matching its performance but making no active attempt to outperform it.

Mutual funds (active)

• Active mutual funds employ an active investment strategy, where fund managers make decisions to buy or sell securities.
• Focus on outperforming the market or achieving specific financial objectives.

2.Expense ratio

Index funds

• Have a lower expense ratio because of passive management.
• Costs are limited to maintaining the portfolio in alignment with the index.

Mutual funds

• Active management and associated research increase costs, leading to a relatively higher expense ratio.
• May include additional fees like exit loads and commissions in some cases.

3.Performance

Index funds

• Aim to match the performance of their benchmark index, not outperform it.
• Returns are potentially steady and predictable, reflecting broader market trends.

Mutual funds

• Fund managers seek to outperform the market, which can result in a relatively higher return potential during favourable conditions.
• Performance hinges on the expertise of the fund manager to navigate evolving market dynamics, optimising the return potential and mitigating risk.

4.Simplicity

Index funds

• Simple to understand and invest in, as they track predefined indices.
• Suitable for long-term, passive investors who prefer minimal involvement and a hands-off investment approach.

Mutual funds

• Can be complex due to varied fund types, objectives, and strategies.
• May require more effort to understand and monitor performance.

5.Risk

Index funds

• Have moderate risk, as they mirror the broader market's performance.
• Investors are exposed to market volatility, but the risk is diversified across the entire index.

Mutual funds

• Risk levels can range from low to very high, depending on the fund type.
• Fund managers play a key role in managing risk through different market cycles.

6.Objectives

Index funds

• Designed for investors seeking returns that mirror market performance.
• Can be suitable for long-term wealth creation with minimal intervention.

Mutual funds

• Target specific goals such as the potential for aggressive growth, steady income, or balanced returns.
• Suitable for investors looking for actively managed, goal-oriented investments.

Index funds vs mutual funds - Which is suitable

Consider index funds if:

• You prefer low-cost, passive investment options.
• Long-term consistency and market-aligned returns are your objectives.

Consider actively managed mutual funds if:

• You are comfortable with relatively higher costs and volatility in a bid to outperform the market.
• You seek a tailored investment strategy for specific financial objectives.

Other features of index funds

• Limited choice for investors compared to actively managed mutual funds.
• May suffer from tracking error if fund fails to accurately replicate the performance of the underlying index.
• Easy to track due to fixed portfolio composition but less flexible to respond to market changes.

Features of mutual funds

• Wide variety of funds catering to different goals such as growth, income, or balanced objectives.
• Potential to outperform the market under favourable conditions.
• Include equity, debt, hybrid, sectoral, and thematic funds.

How to invest in mutual funds, including index funds

Set your financial goals: Identify your investment objectives, risk tolerance, and time horizon.

Research fund options: Evaluate funds based on performance history, expense ratio, and ratings.

Complete KYC (know your customer): Submit required documents like PAN and Aadhaar for identity verification.

Choose an investment platform: Use fund websites, brokerage platforms, or contact a distributor.

Decide investment type: Opt for a lumpsum or Systematic Investment Plan (SIP) depending on your budget.

Monitor performance: Regularly review your portfolio to ensure it aligns with your goals.

Conclusion

The debate of index funds vs mutual funds boils down to your investment style, risk appetite, and financial goals. Index funds provide a low-cost, low-maintenance option for market-aligned returns, making them suitable for long-term passive investors. On the other hand, actively managed mutual funds offer flexibility, variety, and the potential for higher returns, making them suitable for those comfortable with active management and relatively higher associated risks.

FAQs:

Are index funds better than mutual funds?

It depends on your goals. Index funds may be suited to low-cost, market-aligned investing, while mutual funds may be more aligned to a higher return potential through active management, albeit at a relatively higher risk.

Which is riskier: mutual funds or index funds?

Mutual funds can be relatively riskier due to the active management style, which places the onus of risk mitigation on the fund manager. On the other hand, index funds carry moderate risk aligned with broader market performance.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.