Index Funds vs Mutual Funds: Key Differences

Whenever you decide to invest in a mutual fund, the first question which will come to your mind is whether to go for an index fund or an actively managed fund. Both have their unique features, such as risk and returns.  

In today’s blog post, we will give you an overview of index funds and active funds along with their key differences.

What is an Index Fund?

An index fund is a type of passive mutual fund in which the fund manager replicates the performance of an index, such as Nifty 50, BSE 100, etc. and tries to match the performance of the index which it replicates. They are considered a cost-effective investment option for new investors. 

Features of an Index Fund

The key features of an index fund are as follows:

1. Passive Approach: The fund manager adopts a passive investment approach while managing an index fund. They do not actively choose stocks; instead, they replicate the index.
2. Cost-Efficient: Index funds offer a cost-efficient investment option. As the fund manager does not pick stocks actively, therefore, the management cost is very low.
3. Diversification: An index fund invests its money in various companies, which helps the fund manager in reducing risk.

Benefits of an Index Fund

The key benefits of investing in an index fund are as follows:

1. Cost-Effective: Index funds have a lower expense ratio; therefore, they are considered a cost-effective or low-cost investment option for investors.
2. Less Risk: By investing in an index fund, one can get exposure to various stocks, which reduces the risk of the portfolio.
3. Stable Return: The index fund’s post-return matches the returns posted by the index in which the fund is invested.

Read Also: ETF vs Index Fund: Key Differences You Must Know

What are Actively Managed Mutual funds?

Actively managed funds are those mutual funds in which the fund manager actively chooses, buys and sells the securities to beat the market. Their stock picking depends on the internal research conducted by the fund manager; due to this active research, it involves a higher cost. 

Features of an Actively Managed Fund

The key features of an actively managed fund are as follows:

1. Active Management: The Fund manager actively manages and designs the portfolio by conducting their own internal research.
2. Higher Returns: Active funds tend to post higher returns when compared to passively managed funds. Hence, the investor of an actively managed fund gets a higher return.
3. High Risk: Because of the active management of the fund by the fund manager, the risk increases because of higher volatility, and sometimes the fund might underperform the benchmark.

Benefits of an Actively Managed Fund

The key benefits of investing in an actively managed fund are as follows:

1. Outperformance: Actively managed funds have a higher potential to outperform the market because of active management of the portfolio by the fund manager.
2. Customisation: The fund manager actively includes the best-performing stocks and sells the underperforming stocks.
3. Long-term Goal: If an investor wishes to get exposure in a specific sector or style, an active fund provides a more customised portfolio to achieve their long-term goal.

Read Also: Mutual Fund vs ETF. Are They Same Or Different?

Difference Between an Index Fund and an Actively Managed Fund

The key difference between an index fund and an active fund is as follows:

Particular	Index Fund	Active Fund
Approach	They use a passive investment strategy.	In an active management approach, the fund manager actively chooses the securities.
Return	They post returns in line with the benchmark, which it replicates.	They try to outperform the benchmark return.
Cost	An index fund involves lower costs because of a passive investment strategy.	Because of active involvement by the fund manager, it contains a higher expense ratio.
Risk	As stocks in index funds are not chosen by the fund manager, it involves less risk.	An active fund contains a higher risk due to the active selection of stocks by the fund manager.
Suitability	An index fund is suitable for investors looking for a cost-effective investment option.	It is suitable for investors looking for higher returns and who wish to take a higher risk.
Portfolio Turnover	Index funds have a lower turnover ratio because the portfolio changes only when there is a change in the constituents of the index.	Because of higher trades due to active management of the portfolio by the fund manager, the portfolio turnover ratio is comparatively much higher than index fund.

Which is Better Index Fund or an Actively Managed Fund

Choosing between an index fund and an actively managed fund totally depends on the investor’s risk profile and investment objective. If you are looking for a low-cost investment option with lower risk, and are comfortable with a limited return. On the other hand, an actively managed fund is only suitable for investors seeking a higher return, and for this, they are required to take a higher risk.

Read Also: Active or Passive Mutual Funds: Which Is Better?

Conclusion

On a concluding note, both index fund and active fund have their unique advantages and disadvantages, and it totally depends on the investor’s risk profile and their investment objective. Active funds have a higher potential to outperform the market because of the active involvement of the fund manager. However, active funds involve higher risk and are suitable only for investors who wish to take higher risk for higher return. Therefore, it is advisable to consult your investment advisor before making any investment.

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