Index funds versus mutual funds

What are mutual funds?

Mutual funds in an investment vehicle which invest in a portfolio of securities. These securities may be stocks, bonds, money market instruments, gold, silver and real estate investment trusts (REITs) etc. Mutual funds may be either actively managed or passively managed. Passive funds are growing in popularity across the world, especially in the developed markets. Bloomberg has forecasted that in the United States, passive funds will overtake active funds by the year 2026. In India, active funds still dominate the mutual fund industry - actively managed mutual fund schemes account for nearly 85% of the mutual fund industry assets under management (source: AMFI, as on 28th February 2023).

What are active funds?

Active funds are mutual fund schemes managed by professional fund managers, whose aim is to beat the market benchmark index, in other words, the fund managers aim to give investors higher returns than the returns of the market index. In order to beat the market index, the fund managers have to be overweight / underweight on certain stocks or sectors relative to the market benchmark index. This requires considerable effort and resources for research, fundamental analysis, investment strategies, risk management etc. Since the effort and resources for research and fund management is higher in actively managed funds is higher, the total expense ratios (TERs) of actively managed funds are higher.

What are passive funds?

Passive funds are mutual fund schemes which track a market benchmark index like Sensex, Nifty etc. Passive funds invest in a basket of securities which replicate the benchmark index they are tracking. Unlike actively managed funds, passive funds do not aim to beat the market benchmark index; they simply aim to track the index. Since the passive invest in basket of securities that constitute market index, the effort and resources for research and fund management is considerably lower, the TERs of passive funds is much lower than active funds. There are two types of passive funds, exchange traded funds (ETFs) and index funds. In this article, we will discuss the differences between index funds vs mutual funds. Please note that while index funds are also mutual funds, in the rest of the article to explain mutual fund vs index funds, we will refer to active funds as mutual funds, keeping with the popular semantics.

Index funds versus mutual funds - Cost

The Total Expense Ratios TERs of index funds are much lower than actively managed mutual funds. In order to outperform an index fund tracking the same market benchmark index, an actively managed fund will have to beat the benchmark by a margin higher than difference in TERs of the two funds. For example, if the TER of an index and an active fund is 0.1% and 2% respectively, then the active fund will have to beat the benchmark by more 1.9% in order to outperform the index fund. For the same level of performance of the underlying portfolio, lower costs may mean high returns for investors. This is a very big difference if you compare index funds vs mutual funds.

Index funds versus mutual funds – Risk

Total risk in mutual fund investments comprises of two components – Systematic risks and Unsystematic risks. Systematic risk is the risk associated with overall market sentiment and market movements. For example, if the market falls due to macro-economic factors (e.g. lower GDP growth, interest rate hikes etc), geopolitical risks (e.g. war), pandemics etc, it is more likely that prices of most stocks will fall. That is why systematic risk is also known as market risk. Systematic risk is uncontrollable risk.

Unsystematic risk is the risk associated with individual stocks or sectors. For example, if as company reports poor results in its quarterly financial report, then the share price of the company may fall, even though the market may be going up. Unsystematic risk is controllable at a portfolio level; it can be diversified by investing in sufficiently large number of securities. While one can reduce unsystematic risk through diversification, some unsystematic risk will still be there if fund portfolio is overweight / underweight on certain stocks relative to the market benchmark index.

The difference between mutual fund and index fund is that the actively managed mutual fund schemes always aim to beat the market benchmark index. In order to beat the index, the fund managers have to be overweight on some stocks which they believe will outperform the index. Since actively managed mutual funds are overweight / underweight on some stocks, they will have unsystematic risks in addition to systematic or market risk. There is no unsystematic risk in index funds because they invest in the entire basket of stocks in the index they are tracking, in the same proportion as the market index. Index funds are exposed to market risks.

Index funds versus mutual funds – Alpha

An actively managed mutual fund scheme aims to beat the market benchmark index and create alphas for investors. Alpha is the excess risk adjusted return of the fund relative to the market benchmark index. Index funds on the other hand, do not aim to generate alphas – they simply aim to track the market benchmark index. Alpha is essentially the potential higher returns, investors can expect for incurring higher costs in an actively managed fund compared to an index fund. This is a major difference between mutual fund and index fund.

How you should invest?

In this article, we have discussed index funds vs mutual funds. What should investors do? It makes sense to have a mix of both index funds and actively managed mutual funds in your investment portfolio. Index funds may be more suitable for certain market segments and industry sectors, where lower cost works to investors’ advantage. Actively managed mutual funds may be suitable for market segments where the fund managers have a higher potential of generating alphas for investors. The mix of index funds and active funds will depend on your risk appetite. You should consult with your financial advisor and make informed decisions based on your investment needs and after fully understanding mutual funds vs index funds difference.

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