Mutual Funds VS Index Funds - Key Differences

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Difference between mutual funds and index funds

Investing in mutual funds and index funds are two ways to diversify your portfolio. While both allow you to invest in various assets across industries, they have specific differences. Knowing them can help you make an informed choice and assist you in your wealth creation journey. So, what are these differences? Let’s find out.

What is a mutual fund?

A mutual fund invests in a portfolio of securities comprising bonds, stocks and/or other money-market instruments. The primary aim of a mutual fund is to outperform its benchmark index. Professional fund managers oversee investments in mutual funds and take calls on investing your money as per prevailing market conditions and the fund’s objectives.

What is an index fund?

On the other hand, an index fund is a passively managed mutual fund that aims to replicate the index it is tracking. This index could be the Sensex or the Nifty 50 or any other index that the fund is of. The index fund seeks to replicate the index’s performance and holds the same securities in the same proportion as the index.

Mutual fund and index fund: Key differences

The table captures the key differences between an active mutual fund and an index fund in several aspects:

Aspect Mutual fund Index fund
Investment and management style
Fund managers manage active mutual funds. They decide on the combination of assets and their proportion according to the fund's objectives and other market factors. Hence, returns from these funds depend heavily on the calls the fund manager takes and his/her skill sets.
Index funds are passive mutual funds that don't require the intervention of the fund manager. They offer a more hands-off approach to investing as they track popular benchmark indices and aim to replicate their performance.
Expense ratio
Active mutual funds have a higher expense ratio. As they involve a fund manager who constantly strives to generate alpha (outperformance over the benchmark), the fund house's cost of managing a mutual fund is high. Because of this, the expense ratio is relatively higher for actively managed mutual funds.
As index funds are passive mutual funds, they require negligible or no intervention from the fund manager. Hence, their expense ratio is comparatively lower than actively managed mutual funds.
Simplicity of investment
Mutual funds require detailed research before investing; you must analyse past returns, check the fund manager's track record, etc.
Index funds are simpler to understand, especially for beginners, and the decision to invest in them mostly comes down to tracking error and expense ratio. Tracking error refers to the deviation in the fund's return from its replicating index.
Risks involved
Risks depend on the fund's investment strategy, market capitalisation, etc. For e.g., alarge-cap fund is relatively less volatile than a mid-cap and a small-cap fund.
The risk depends on the index the fund is tracking. For example, the Nifty 50 is relatively less volatile than the Nifty Next 50.

Mutual fund or index fund - what to choose?

The choice solely depends on your financial goals and risk tolerance. A new investor should start with an Index fund, and an investor who understands risk, returns, and fund objectives can check actively managed funds..

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In conclusion

A mix of active mutual funds and index funds can help you get the best of both worlds. In case of any doubt, consult your financial advisor, who will help you make the right decision based on the goal you want to achieve.

FAQs on difference between mutual fund and index fund

Both index funds and active mutual funds help you generate decent returns on your investment. The choice will depend on your goals and preferences.

Index funds as well as active mutual funds carry some element of risk. Index funds are relatively less risky than many actively managed mutual funds.

The major disadvantages of index funds are the lack of downside protection and the fact that they can’t generate alpha.

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