Mutual Fund vs Index Fund: Which Is Better?

In the realm of passive investments, index funds and mutual funds are two key players. As investment products, they both offer a set of advantages to investors. If you are at the juncture of decision-making, this article delves deep into the key differences, advantages, and considerations of each investment approach.

What Are Mutual Funds?

Mutual funds are an investment vehicle that invests a consolidated fund into a diversified portfolio of securities, including equity, bonds, commodities, etc., to generate risk-adjusted, long-term returns. Mutual funds allow investors to take exposure to the market without holding the security directly.

A mutual fund is a form of passive investment, where the fund is managed by the fund managers. The fund manager is responsible for identifying profitable investment options within the definition of the fund.

Read More About: What is Mutual Fund?

What Are Index Funds?

An index fund tracks the performance of a market index such as the BSE Sensex or NIFTY50.

The fund’s portfolio contains all the stocks from the index or a representative sample, and it closely replicates the returns of the index.

Unlike mutual funds, which can be actively or passively managed, an index fund is always a passively managed fund. These are low-cost and, hence, a good option for passive investors looking for long-term capital growth.

It is also easy to track the performance of an index fund since it follows the market benchmark. The fund will make money when the index rises. Similarly, the fund’s performance will decline when the index it follows falls.

Differences Between Index Funds and Mutual Funds

The table below showcases mutual funds vs index funds.

	Index funds	Mutual funds
Investment objective	Designed to generate returns close to the index it follows	The primary objective of the mutual fund is to generate index-beating returns
Investment securities	Invests in equities, bonds, and other securities	Stocks, bonds, and other securities
Fund type	Close-ended fund	Open-ended fund
Portfolio composition	The portfolio composition is similar to that of the index it follows	The fund manager uses discretion and judgement in selecting securities
Expense ratio	Lower expense ratio	Higher expense ratio than index funds
Fund management	Passively managed fund. The fund manager has no active participation once the fund is created	Actively and passively managed. Performance depends on the expertise of the fund manager
Flexibility	Flexibility is low. The fund tracks the performance of a benchmark index and mimics its performance	Mutual funds are deemed more flexible to adjust to the changing market conditions
Risks	Index funds are low-risk investments	Actively managed mutual funds carry higher risks than index funds

What Are Actively and Passively Managed Funds?

We have learned that index funds are passively managed funds. But, what does it mean?

When it comes to index vs mutual funds, the fund management style is the major differentiator.

Passive management: A passively managed fund replicates the returns of market indices. Companies incur fewer costs in managing an index fund, which lowers the expense ratio.
Actively managed funds: Mutual funds can be actively or passively managed. It is actively managed if the fund manager handpicks the securities for investing and adjusts the fund to earn market-beating returns. Since they involve direct decision-making, actively managed funds have higher fees.

Advantages of Investing in Index Funds

Diversification: With index fund investments, you receive immediate diversification. It allows you to access a niche market with the best-performing stocks.
Low-cost investment: Index funds are cheaper than actively managed funds. A lower expense ratio means more money for the investor.
Easy to track performance: Index funds are easy to understand and track because of their closeness to the market index. The fund will generate returns similar to the index returns.
Better returns: Index funds may offer better long-term returns than actively managed mutual funds. The return on index funds is free from biases and judgmental errors.

Disadvantages of Index Fund Investing

No downside protection: Index funds replicate the portfolio of the index they follow, so there is little room left for adjusting the portfolio during a market downtrend. In actively managed mutual funds, the fund manager adjusts the fund for underperforming securities and boosts the fund’s performance.
No control over holdings: The stocks and weightage of each stock in the portfolio remain the same in an index fund. The passive fund manager can’t change the composition of the portfolio, which gives them little control over the fund’s performance and the returns generated.

Mutual Fund vs Index Fund: Which Is Better?

While weighing your options between mutual and index funds, your personal investment style, risk tolerance, and investment goals are the major differentiating factors. However, as a general rule, index funds may outperform actively managed mutual funds in the long run. It is because even the most experienced managers can’t continue to generate market-beating returns.

Final words

In conclusion, both mutual funds and index funds offer unique benefits that appeal to different investor groups. Mutual funds provide active management and diversification, while index funds offer simplicity, lower fees, and the potential to closely match market returns. The final choice, however, rests on individual investment goals and preferences.

FAQs

Are index funds the same as mutual funds?

Index funds are passively managed mutual funds. An index fund portfolio follows the composition of a major market index and generates returns close to the index. Since these are passively managed, their charges are lower, which ultimately results in higher returns for the investor.