In today's world, investors may often feel spoilt for choice amongst the many options available for investing. With a wide variety of mutual funds to choose from, they may struggle to find a suitable scheme for themselves.
Across different mutual fund schemes, investors can manage their funds by opting for actively or passively managed schemes. While active investing requires investment decisions to be taken by fund managers, passive investing generally works by tracking benchmark indices/price of a commodity instead. Index funds are a category of mutual fund schemes that follow passive investment strategies.
Here are a few key differences between index funds and other mutual funds.
Investing strategies
This is the primary difference between the two categories. In an actively managed mutual fund, the fund managers select particular securities and their weightage based on the fund's specific investment strategy. Such choices are backed by adequate research undertaken by analysts.
In contrast, index funds adopt a passive investment strategy. It means that an index fund tracks an underlying index or price of a commodity, such as S&P BSE Sensex, NSE Nifty 50, Gold prices etc. The fund management team needs to track changes in the underlying index composition and aim to replicate the same in the fund's investment portfolio. Considering this strategy, some investors may find the investment process for index funds easier to understand.
Alpha generation
Actively managed mutual funds aim to outperform the benchmark indices by making active investment decisions. As such, the investment objective of such funds is to generate better returns for the investors. The additional return generated by the scheme, over and above the benchmark returns, are referred to as alpha.
In contrast, the returns of an index fund will aim to replicate the returns generated by the underlying index (subject to scheme expenses and tracking errors). Since the fund cannot deviate from the index composition and weights, index funds may not end up generating alpha for their investors in a majority of cases.
Discretion on stock selection
Actively managed mutual funds provide flexibility and discretion to fund managers to choose stocks and their weights per their investment outlook. While there might be some restrictions in specific mutual fund categories to not go beyond the broader investment mandate and restrictions according to SEBI guidelines, fund managers can select stocks within a given range.
In contrast, index funds do not allow going beyond the securities in the underlying index or changing the weights of such securities. As per SEBI (Securities and Exchange Board of India) Guidelines, index funds should invest at least 95% of their total assets in securities which the underlying index is tracking.
Scheme expenses
An actively managed mutual fund may have comparatively higher management charges due to the active fund management strategy. Such charges form part of the overall scheme expenses charged to the fund, directly impacting the overall investor returns.
In contrast, passively managed funds may carry lower fund management charges due to the limited role played by the fund management team. As such, they provide an alternative low-cost investment option with exposure to the underlying index.
Investment risk
It is helpful to understand systematic and unsystematic risks to mitigate investment threats. Systematic risk refers to unfavourable market events adversely impacting the investment portfolio, which are considered imperative to all market-linked investments. On the other hand, unsystematic risk refers to the risk not shared with a wider market or industry. These are often specific to a particular company and they may adversely impact the portfolio returns.
Actively managed mutual funds are exposed to both risks, systematic and unsystematic. This is because the fund managers make regular investment decisions, which may positively or negatively affect returns.
In contrast, fund managers handling index funds don't enjoy any discretion to invest beyond the underlying index. Therefore, unsystematic risks may be considered as automatically eliminated in index fund investments.
Portfolio turnover
Actively managed mutual funds generally tend to have a higher portfolio turnover ratio as the fund managers aim to make regular and active investment decisions to generate alpha for the investors.
In contrast, portfolio turnover for index funds may be lower, as changes happen to the investment portfolio during index rebalancing, which may not be frequent.
With the above differences in consideration, investors should make an informed choice on investing in actively managed funds or index funds, depending on the return expectations, risk appetite and investment horizon.
