Mutual funds tend to have higher fees than index funds but, mutual funds basically do the same thing that an index does. That means that they are both diversifying your portfolio across hundreds of stocks. An index fund still diversifies you, but it tracks a very specific index. Aimed at offering broad market exposure, an index fund is constructed to track a certain market benchmark, such as the S&P 500. Although an index fund can be considered a form of mutual fund, an index fund is a “hands-off” sort of vehicle that doesn’t try to beat the market. Instead, it tries to reflect the market.
As an investor, if you want to create wealth over the medium term (3-5 years) with medium volatility, most advisors would recommend you to invest in a large cap equity mutual fund, which in turn invests majorly in large companies. Now, you have 2 investment options in mutual funds:
- Actively managed funds — Here the fund manager decides which companies/sectors to invest in and which not to invest in, based on his/her understanding of the market and the expected performance of the companies/sectors. Most large/mid/small cap mutual funds, which we regularly hear about, are actively managed mutual funds. Since we are concentrating on investment in large companies, we will focus on large cap mutual funds.
- Passively managed funds — These simply imitate the composition of an index which can be any of Nifty50, Nifty Midcap100, BSE Smallcap, etc. Index funds are an example of passively managed mutual funds. For example, an Index fund tracking Nifty50 will invest in all the 50 companies just like the index itself. Since we are concentrating on investment in large companies, we will focus on Nifty50 Index funds for comparison with large cap mutual funds. NIFTY 50 is the index of 50 largest companies based on free float market capitalization methodology i.e. based on the value of shares of the company in active circulation.
Many mutual fund advisors say 2020 is going to be extremely crucial for the actively-managed funds. They believe it would become difficult to justify their inclusion to clients If these schemes fail to put up better show three years in a row.
Finally, what should be your strategy? If you are investing in actively-managed large cap funds, continue with your investments. However, if you are starting your investments, you may split your investments between actively- and passively-managed schemes, say mutual fund advisors. Also, keep a close watch on this space for a firm trend, they add.
In India,if we see the performance of mutual funds and index funds over the last few years, we will see mutual funds has outperformed index funds in between 2009 to 2018.
Main differences between Index funds and Mutual funds
Both Index Funds vs Mutual Funds are popular choices in the market; let us discuss some of the major Difference Between Index Funds vs Mutual Funds.
- The Index funds are defined as a fund that will track a security market index and its traded like ordinary securities or the stocks. An index fund is a type of investment vehicle which will track the performance of the benchmark market index.
- Index funds are traded on a recognized exchange. On another hand, direct investment cannot be made in an index fund. But you can purchase an ETF and mutual fund that can either be bought at regular intervals through Systematic Investment Plan (i.e. SIP) or in a lump sum.
- Index funds are priced and traded throughout the day. On the flip side, mutual funds are priced at NAV which is determined at the close of the trading day.
- Pricing of an Index fund is based on supply and demand of the securities in the capital market. To the contrary, a mutual fund is priced as per the Net Asset Value (i.e. NAV) of that underlying asset.
- In Index funds only, manual orders will be placed that is you need to sign in to place the buy order while in the case of a mutual fund, one can automate its investment through Systematic Investment Plan by giving standing instructions to the bank.
- The liquidity and flexibility are comparatively higher in index funds than in a mutual fund.
- The trading fees of index funds like ETF is high. As contrary to an index fund, in case of mutual funds there are no or low trading fees.
Index Funds or Mutual Funds, whom will you choose in COVID pandemic situation?
At a time when the stock markets have seen a sharp fall since the outbreak of Covid-19 pandemic and prices of many shares have hit their multi-year lows, investors have to select stocks of those companies which have a fundamentally strong balance sheet. However, instead of looking at select companies, an investor should ideally invest in index funds, which will have stocks of market leaders across different sectors.
Index funds invest in stock market indices in the same shares and in the same proportion. These funds are passively managed and the fund managers’ intervention is very limited. The asset allocation of an index fund would be the same as that of its underlying index. As the expense ratio of index funds is lower (10 to 50 basis points) than other actively managed funds of asset management companies, returns generated can be higher in the long run. In the current market volatility, passive investments can help an investor to mitigate the unsystematic risks—betting on few select stocks going wrong.
As the current market scenario is complex and the dynamics change very fast, investors must carefully select the index. Ideally, an investor should invest in diversified funds like Nifty or Sensex funds. If an index fund is benchmarked to the Nifty, the portfolio will constitute the same 50 stocks as the benchmark. Individual investors who are not market savvy should stick to index funds for convenience, liquidity and ease of investing.
Therefore, an index fund helps an investor balance risks in the portfolio as the fund matches its performance to that of its index. If an investor does not want to take risk of near-term under performance and is expecting predictable returns, he should look at index funds. As such funds can see short-term fluctuation, investors must stay invested for the long term for the fund to generate higher returns.
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