Index Funds vs Mutual funds: A Beginner’s Guide
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In a hurry? Read this summary:
Diversification is key for effective investment planning, which mutual funds offer a simple way to achieve. Before investing in them, though, it is essential to understand the different types of mutual funds and how each of them compares to the other.
Amongst these, index funds have recently emerged as a popular option. Read on to understand how index funds fit within the broader mutual fund universe — and yet, how they differ at the same time.
Mutual funds are pooled investment instruments that invest their capital in a mix of assets, including equities, debt instruments, or a mix of both. Investing across asset classes, sectors, geographies, and market capitalisations helps reduce concentrated risks and balance capital appreciation and a stable income. One can choose to invest in them via a one-time lumpsum payment, or invest pre-determined amounts in them at fixed intervals, under a systematic investment plan (SIP).
Depending on whether mutual funds look to beat market performance or simply replicate it, they are classified as actively or passively managed funds. In actively managed funds, managers regularly review and rebalance asset allocation to generate returns above benchmark indexes, with passively managed funds, the goal is simply to track and match the performance of underlying indices or sectors with little to no intervention.
Index funds track and replicate the performance of specific market indices, by investing in their constituents in the same proportion. To qualify as an index fund, they must invest at least 95% of their capital in said securities, per SEBI (Securities Exchange Board of India) rules.
Those with low-to-medium levels of risk tolerance may consider investing in them, as they offer diversified exposure to equity markets. Since portfolio composition isn’t actively rebalanced, index funds tend to have relatively lower expense ratios as well, which further enhances returns. This makes them appealing to beginner and seasoned investors alike.
That said, there may at times be gaps between the performance of these funds and their underlying indices. This is referred to as a tracking error, and can be caused by expense ratios, transaction costs, delays in rebalancing in the fund when the index changes its composition, and other such factors. Generally, the lower the tracking error, the better the returns one can expect from these funds in the long run.
When one refers to mutual funds, they often picture actively managed schemes that aim to beat the market. Passively managed options such as index funds have recently gained significant ground however, amongst risk-averse and conservative investors. While index funds fall under the broader mutual fund universe, their approach, along with cost, and performance outcomes differ in important ways.
Here’s a closer look at how they compare:
Investment approach
Index funds are passively managed instruments. Portfolio composition is based on that of the underlying index. Those looking to take a more hands-off approach to wealth creation may consider investing in them.
Mutual funds may be either passively or actively managed. In case of the latter, portfolio managers actively review and rebalance a fund’s holdings in response to market conditions, capitalising on emerging opportunities and mitigating impending risks. They are therefore more suited to those looking to take a more proactive approach when it comes to long-term wealth creation.
Risk levels
Both index funds and actively managed mutual funds provide one with portfolio diversification. However, just like any other market-linked instrument, they do have a certain degree of risk associated with them as well. The difference lies in the levels of said risk, stemming from varying management approaches.
Since index funds passively track benchmark indices, their portfolio compositions remain relatively stable. This lowers volatility and makes performance more predictable which may appeal to risk-averse investors (for example, those who will be retiring soon).
On the other hand, actively managed mutual funds are frequently rebalanced, in a bid to capitalise on opportunities and avoid downturns. While this could result in potentially higher returns, it also makes them more prone to volatility arising from manager bias and potential emotional investing. As such, those with higher levels of risk tolerance (such as those starting out in their careers) may consider investing in more actively managed mutual funds.
Choosing between index funds and mutual funds requires a thorough analysis of one’s preferred approach to wealth creation, their investment expertise, and risk tolerance. To know more about how each of these fund categories can fit into your broader investment portfolio and get started on your investment journey today, visit SC Invest on the SC mobile app or contact our representatives today.
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