In the past few years, India has witnessed a significant shift from actively managed mutual funds to passive funds such as Index funds. Experts believe that the rationale behind such a shift is that the idea of actively managed funds outperforming their benchmark is not necessarily true. Thus, investors feel it makes little sense to pay comparatively higher expenses towards actively managed funds, and opting for index-tracking funds can reap greater benefits in the long run.
In this blog, we will highlight the key features of both mutual funds and index funds for investors to make an informed investment decision.
Mutual funds combine the wealth of investors who willingly pool their funds. A fund manager manages the pooled funds on behalf of the mutual fund investors. He/she is in charge of purchasing securities such as stocks and bonds as per the investment aim of the fund.
Index funds invest the pooled funds in stocks of the chosen index in the same proportion as the index (Sensex or Nifty). Index funds in India are usually benchmarked to either the Nifty or the Sensex. These are called passively managed funds as the fund manager does not pick stocks based on any portfolio strategy. The index fund manager modifies the index fund portfolio only when the index weights change or if there is an addition or deletion of stocks from the index. An index fund aims to replicate the index returns as far as possible.
Here are some broad differences between index funds and mutual funds:
Index Funds | Actively managed mutual funds |
Replicates the performance of the selected benchmark index. | Invests in a basket of securities that are actively traded on the stock exchange. |
Passive management style | Active management style |
Lower expense ratio as compared to actively managed mutual funds. | Higher expense ratio due to active management style. |
Since Index funds are also a type of mutual fund, their value is determined using end-of-day NAV. | End-of-day NAV is considered to determine the value of a mutual fund unit. |
A relatively new form of investment. | Actively managed mutual funds have been around for much longer in the Indian market context. |
Every investor has the choice of either being an active investor or a passive one. So, how are the two different? Here’s how:
Since index funds are exposed to market risk, the fund returns may fluctuate depending on overall market performance. Since the composition of the fund is dependent on the index, this risk is mostly unavoidable. Actively managed funds, on the other hand, can limit this risk since the stock selection is manual and stock performance may or may not be influenced by market fluctuations.
The question still remains, how do you decide between actively managed mutual funds vs index funds? How are index funds better than mutual funds and what factors should be considered before making an investment decision? In the below section, we will discuss some relative advantages of index funds over mutual funds.
Some primary reasons investors must select index funds over mutual funds are:
For investors who are looking to measure the drawbacks of index funds, here are some important factors to note:
For investors looking to diversify their investment portfolio, it makes sense to invest in a mix of index funds and actively managed funds. For Ex : Index funds could easily replace large-cap mutual funds and investors could choose a well-managed mid-cap or a small-cap fund. Both these include unique strategies and therefore provide different returns depending on market conditions.
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