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Index Funds vs Mutual Funds: Which Investment is Good?

IndianMoney.com Research Team | Posted On Wednesday, December 18,2019, 04:44 PM

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Index Funds vs Mutual Funds: Which Investment is Good?

 

 

As investors, most of us know the benefits of diversification of our investments over various assets. Index funds and mutual funds are often preferred by investors in search of avenues to diversify their portfolios. However, it is important to know the difference before deciding to invest in either of these asset classes.

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What are Index Funds?

Unlike mutual funds, index funds do not aim to outperform the market but maintain uniformity. It creates your portfolio by tracking the composition of the standard market index like Nifty 50 or Sensex. The main objective of the index funds is to replicate the index performance and generate returns at a lower cost. It does not aim to outperform the market, but give returns while maintaining its uniformity. Thus, investors can balance the risk and returns in their investment portfolio.

What are Mutual Funds?

A mutual fund is an investment type where the funds are pooled from various investors for investing in company shares, stocks or bonds. Mutual fund portfolios are shared by thousands of investors and are collectively managed by fund managers. These investments navigate through the market fluctuations and earn the highest possible returns.

Advantages of Investing in Index Funds Over Mutual Funds:

  • Index funds do not have minimum purchase criteria unlike mutual funds
  • Index funds are known to give predictable returns at minimal cost
  • They are also more liquid than mutual funds
  • Some ETF funds have greater tax advantage then open-ended mutual fund schemes.

Index Funds vs. Mutual Funds: Which One is Better?

Since mutual funds are actively managed funds, fund houses must employ a group of professional stock pickers to manage the portfolios and help investors generate market-beating returns. Thus mutual funds require investors to bear a higher cost due to the additional overhead expenses incurred on paying these professionals. Thus a lot of mutual fund houses charge high fees based on the performance of a mutual fund portfolio.

Index fund does not charge much in terms of fees. Instead of hiring professionals to give high returns, index funds simply buy a specific number of stocks and holds them in proportion to their importance in the index. For example, if index funds track the benchmark like the nifty, then its portfolio will have the 50 stocks that comprise nifty, in the same proportion. Since matching the index is very inexpensive, thus the fund houses are able to pass these funds to investors at lower fees.

Let’s take a look into the following factors so that you can decide for yourself:

-Cost of Investment:

The annual expense ratio is index funds is low since they are passively managed whereas the annual expense ratio of mutual fund investments are high since fund houses engage a stock market professional to generate market-beating returns.

-Risk Ratio:

Talking about the risk factor, index funds are less prone to equity-related risks as they track an index. Actively traded funds are exposed to share market fluctuations as they heavily invest in company equities. However, investors must switch to a mutual fund during a market slump as index funds tend to lose their value during a market slowdown. But in case of mutual funds, you will have the option to switch funds during market volatility. The fund manager ensures you get the best returns on your investments.

-Return on Investment:

Index funds are known to give predictable returns by tracking the performance of an underlying benchmark. They do not aim to beat the benchmark but match its performance. But the returns generated may be lesser than the index due to tracking errors.

On the other hand, mutual funds are known to give market-beating returns. The returns are generated by investing in various asset classes to mitigate risk. When one asset class underperforms, the gains from other assets make up for the losses.

How Do Index Funds and Mutual Funds Help to Build Wealth?

Mutual funds are a great way to grow your wealth. These funds are registered with SEBI and are thus considered to be safe investment options. Some actively managed fund has the potential to give market-beating returns provided investors remain invested for a long investment horizon of say 10 to 20 years.

Now if we compare the investment horizon with index funds, investors can comfortably make 9.5-10% returns minus the fees. But in case of mutual fund investments, not all mutual funds can guarantee market-beating returns minus the fees. For this reason, risk-averse investors are simply better off with average returns minus the fees by investing in index funds. Investors willing to take risk can invest in actively managed funds while aiming for the highest possible returns.

See Also: How To Invest In Mutual Funds Online?

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