Did you ever wanted to know –
What is an Index Fund?
What is the difference between an Index Fund and a Mutual Fund?
Which one is the best when it comes to capital growth?
What are the advantages of an Index Fund over an Actively Managed Mutual Fund?
Where should I invest in 2020?
And much more?
In this article, we are going to clear all your doubts related to Index fund vs Mutual Fund. So stick till the end to get the answer to all your queries in this matter.
When it comes to Investing in the Stock market, most of the retail investors choose to invest either through an Index Fund or through a Mutual Fund. And for wealth generation choosing the right investment vehicle is crucial. But how to know that you have chosen the correct investment vehicle for your goals?
Before we start let us have a small discussion of the legality and regulation side of Index Funds and Mutual Funds in India.
Who Regulates Mutual Funds in India?
All kind of Mutual Funds whether it is Index Funds or Actively Managed Mutual Funds, it is regulated by SEBI or the Securities and Exchange Board of India as it involves managing investor’s money.
But you must have heard about AMFI, then –
What is AMFI?
AMFI or Association of Mutual Funds in India is a Non-Profit Organization whose aim is to develop the Mutual Fund Industry in India through promoting professional, healthy and ethical environment to safeguard the interest of Mutual Funds and its Investors.
The members of AMFI comprises of 44 SEBI registered AMC or Asset Management Company.
Now as we know that it is fully safe to invest either in an Index Fund or in a Mutual Fund and the investor’s interest is protected, let us dive a bit deep into Index Fund vs Mutual Fund.
What is an Index Fund?
An Index Fund is a kind of Mutual Fund which tracks the benchmark Indices of the financial market of a country.
In India, most of the Index Funds either track NSE’s Nifty 50 or BSE’s Sensex. But there are many Index Funds who track other Indices like the Nifty Next 50, Nifty 100, Nifty Midcap 150 or some thematic Index like the Bank Nifty.
The portfolio of an Index always made up of the same stocks or bonds that are present in the underlying Index. For example, if an Index Fund is tracking the Nifty 50 Index then the portfolio of fund will only contain the 50 stocks present in the Nifty 50 Index.
An Index Fund is a kind of Passively Managed Mutual Fund, so the Fees charged (also known as Expense Ratio) by Index Funds are low compared to the traditional Mutual Funds. And most of the time an Index Fund will rise or fall as much as the Index it is imitating.
Investing through an Index Fund is a very good and safe way of diversifying your portfolio as most of the benchmark indices contain big and established companies. And it is also loved by retail investors who don’t want to burn their hand while investing in the stock market.
What is a Mutual Fund?
A Mutual Fund is an Investment Fund where it pools money from many investors to invest in securities. Most of the time Mutual Funds are Actively Managed Funds which means an individual Fund Manager or a group of them proactively make decisions for the betterment of the investors.
A good Actively Managed Multi-Cap Mutual Fund is a very good option for having a very well-diversified portfolio as these kinds of Mutual Funds invest in stocks from different market capitalization, and are vetted by experts.
Investing in Actively Managed Mutual Funds are a lot less risky than investing in individual securities as Mutual Funds gives two of the most important safety nets – “DIVERSIFICATION” and “RISK SPREAD”. Most of the retail investors who do not want to learn the tedious craft of making their own portfolio goes for these kinds of Mutual Funds.
But as these kinds of funds are actively managed by a Fund Manager and a team behind him, they are generally expensive in terms of Fees or Expense Ratio.
So the next question that automatically comes is –
What is Expense Ratio in Mutual Funds?
Simply put, Expense Ratio is the Fee charged by Mutual Funds to manage the total investment portfolio annually.
It doesn’t matter whether the fund made a profit or loss at the end of the year, Expense Ratio is just a recurring yearly fee. So even if a fund losses its investor’s money they still get to charge the Fee or Expense Ratio.
Let us understand the concept of Expense Ratio with an example.
Let us say a particular Mutual Fund is charging an Expense Ratio of 2%. Then at the end of the year, 2% of your total capital will be deducted no matter whether the fund made profit or loss in that particular year.
If the fund made an annual profit of 12% then the annual profit on your investment on the fund will be 10%.
If the fund losses 3% on an annual basis then the annual loss on your investment will be 5%.
That is why Expense Ratio becomes a major factor among many others while selecting a Mutual Fund to invest in.
Index Fund vs Mutual Fund
Difference Between Index Fund vs Mutual Fund
- Expense Ratio -The very first difference that we discussed above is Expense Ratio. From the earlier examples, we can see that Expense Ratio plays a major role when selecting a fund.
As Index Funds are generally passively managed funds which means there is no fund manager behind the fund taking investment decisions, that is why Index Funds tends to have a much Lower Expense Ratio compared to Actively Managed Mutual Funds.
- Investment Style – Index Funds are mainly used by investors to invest in an Index specific portfolio. Whereas Mutual Fund Investment can be Thematic, Sectorial, Market Capitalisation Specific, Tax Relief or some time Fund Manager Specific (Investors sometimes invest in a fund just because it is managed by a specific individual).
- Active or Passive – For a Passive Investor Index Fund can be a great choice. The investor doesn’t need to look up how his investment is doing on a weekly or monthly basis (watching your investments daily causes panic and nothing more). An Index Fund will perform as good as the underlying Index does itself.
But in case of Actively Managed Mutual Funds, an Investor needs to review his investments at least on a monthly basis.
If the fund you have selected is underperforming for at least 2 quarters or 6 months compared to its category average then we suggest you need to revisit the drawing board.
- The Objective of The Fund – The goal of an Index Fund is completely different from a Mutual Fund.
An Index Fund aims to give its Investor the exact same return the underlying Index provide minus the Fee or the expense of the Fund. Whereas an Actively Managed Mutual Fund aims is to beat the benchmark Index it compares itself to as well as its category average.
- Relative Safety – Though investing in the stock market is a risky business and you should always consult a certified financial expert before making any investment decision, Index Funds are generally considered safe compared to Actively Managed Mutual Funds.
By aiming for similar returns as the benchmark Indicies, Index Funds takes less risk so the money invested in Index Funds are safe compared to Mutual Funds. In an Actively Managed Mutual Fund, the Fund Manager might take higher risk to generate better returns.
If you want to know the benefits of Investing in Index Funds in details then we would suggest you read The Little Book of Common Sense Investing by John Bogle, former chairman of Vanguard Group of Mutual Funds.
Which One Should You Choose Between Index Fund vs Mutual Fund?
The answer to this question falls under the notorious category of ‘IT DEPENDS’. It depends on multiple factors. We know it is irritating when you see an answer to a question saying ‘It Depends’ but here it really does. There is no one size fits all in this segment. Which fund will suit you the best depends on your goal, investment horizon, risk capacity, time to spare for regular review, etc. But we can make a basic blueprint for each category.
Index Fund vs Mutual Fund in the context of the India Economy
Warren Buffet once said that Index Funds are ‘the most sensible equity investment for most people’. This is very true but “in the context of the US economy”.
The US economy is one of the developed economies in the world. And the US Stock Market is also very efficient, meaning the US Stock Market rewards a good company and penalizes a bad one, very fast. There is a very little chance for you to catch a good company in its budding stage.
But here in India, we are a developing economy and the Indian Stock Market is not so efficient compared to the US Stock Market. So there is ample chance for you to catch a good company when it is in a growing stage. We have already proved this concept by doubling our money.
It is very hard to beat the Index of the stock market of a developed economy as Fund Managers find it’s tough to select a good stock when it is cheap. Whereas in India, it is easy for the Fund Managers to find quality stocks at a cheap valuation. And there are multiple Instances in India where Actively Managed Mutual Funds has beaten the Index by a considerable margin for a long time.
Index Fund vs Mutual Fund in the context of Investment Allocation according to Market Capitalization
When you invest in an Index Fund in India, you are either investing in the Top 50 Companies of the Indian Stock Market through a Nifty 50 Index Fund or the Top 30 Companies through a Sensex Index Fund.
It is the safest way to invest in the stock market but you do not have the flexibility to switch to a different market capitalization when the valuation of the Large Cap stocks become expensive. (Top 50 or Top 30 Companies in the stock market are essentially Large Cap stocks).
Whereas in a Multi Cap Mutual Funds, the Fund Manager has the flexibility to stop investing in a particular market cap when the valuation of that segment becomes expensive and the Fund Manager can divert the incoming investment capitals towards cheap valuation. In some rare cases, some Mutual Funds had even closed their investment option as the fund manager thought that the market was at peak valuation.
Though Index Fund Investing is passive, but the investor has to select on its own how much he or she wants to allocate to a particular market cap. Whereas in Actively Managed Mutual Funds, a professional expert is taking that decision for you.
A basic rule of thumb when making a portfolio out of Index Funds is 60-30-10.
60% in Large Cap Funds – 30% in Mid Cap Funds – 10% in Small Cap Funds. If you want a super defensive portfolio of Index Funds then drop the Small Cap and divert 70% of your Investment Capital towards Large Cap Funds and 30% of your Investment Capital towards Mid Cap Funds.
Who Should Invest in Index Funds?
If you want a passive, low risk, low expense, investment vehicle and you do not have time or want to follow up on your investment and you want a hands-free investment experience then you should invest in an Index Fund.
The inherit ‘Fire and Forget’ nature of Index Funds makes it an excellent choice for passive investors. Once you are invested in an Index Fund, you do not need to follow your investment daily because the return of the fund will be inline with Index the fund is imitating.
Index Fund Investing is one of the best ways to dip your feet in the equity market if you are a novice investor.
If your goal is to earn a better return than just what the Index is providing then Index Fund Investing is not for you. If you are a seasoned investor in the equity market then you might find better returns in other kinds of investment vehicle. If your investment horizon is short (less than 5 years) then Index Fund Investing is not for you. If your goal is to save taxes then Index Fund Investing is not for you.
Who Should Invest in Mutual Funds?
If your goal is to generate better returns than the Index and your risk capacity is higher than the average retail investor and you can afford the Expense Ratio associated with Actively Managed Mutual Fund and if you are a seasoned investor who can spare time to track their investment on a timely manner then Mutual Fund Investing is for you.
If you cannot afford the time and you do not know how to properly research and analyze Mutual Funds then Mutual Fund Investing is not for you. Just like stock selection takes time and the selector needs to have a good grasp on Fundamental analysis, same goes for Mutual Funds.
Mutual Fund provides a path for wealth generation only if the investor is a seasoned one. Risk in Mutual Fund can be similar to that of equities, debt or commodity as Mutual Funds are market-linked products.
But if you want to use your investments as tax relief instrument then Mutual Funds provide an excellent way to do that.
Under Section 80C of Income Tax Act of 1961, an individual can save up to Rs. 1,50,000/- or Rs. 1.5 Lakh. If you invest in ELSS or Equity Linked Savings Scheme Funds you can take advantage of this clause.
If you want to know more about the Act then please visit the website of Income Tax Department of India.
Enter 80C under Section No.
And then click Search.
For more information of ELSS Funds you can visit the website of Mutual Fund Sahi Hai.
How to Get More Return in Mutual Fund?
There are many categories upon which Mutual Funds are classified into, but when it comes earning more return from the same fund then there are 2 categories you need to look for.
Regular Funds and Direct Funds.
The same fund can be available on both categories. Let us understand this with an example.
In the above picture, you can see that the DSP Healthcare Fund is available under both Regular Funds and Direct Funds.
Regular Funds means that the broker or the middleman is going to get a commission when you invest in a Regular Fund. Whereas in a Direct Fund there is no broker or middleman involved so there is no commission cut on your investments.
You can also see that the Return of the Direct Fund is higher than the Regular Fund. This is because of the ‘Commission Cut’ on the investment when investors buy the fund’s unit is not present in Direct Funds. There is no broker or middleman taking a cut out of your profits in Direct Funds.
We suggest you should always buy the Direct Fund of the Mutual Fund of your preference as it earns you more return than the Regular Fund.
How to Buy an Index Fund or a Mutual Fund in India?
There are multiple ways or platforms through which you can buy Index Funds or Mutual Funds in India. But here in this Index Fund vs Mutual Fund showdown, we are going to discuss the 2 easiest way to buy funds in India.
If you are using full-service brokers like Sharekhan, then most probably you will only get the option to buy the Regular Fund version of the fund of your choice. So we would suggest you to avoid using a full-service broker when investing in Mutual Funds.
We suggest you use either of the 2 ways discussed below to buy Index Fund or Mutual Fund in India.
This is the easiest of all the ways. We have already discussed in details How to Invest in Mutual Funds through Upstox in our Upstox Review, please give it a read if you want to know more.
Groww Mobile App
With the evolution of technology, investing in Mutual Fund is on your fingertips. Now you can invest in Mutual Funds with just your Smart Phone.
How to Buy Index Funds or Mutual Funds in Groww App?
What Documents do You Need to Open a Groww Account?
- PAN Card
- Aadhaar Card
- Photo of Your Signature
- Email Address and Mobile Number to receive OTPs
Scan this QR Code using your Smart Phone if you are viewing this page on a Desktop Computer.
Or click on this LINK if you are viewing this page on a Smart Phone.
Install the Groww App on you Smart Phone.
Follow the on screen process and complete your registration.
Provide your PAN number and Bank details and proceed.
Upload the photo of your signature and continue to verify your account.
Verify your Account using Aadhaar OTP verification. You Aadhaar Card must be linked with your mobile number in order to complete the verification.
Now log in to your account using the PIN that you have set during the account opening process.
After you have logged in to your account, you will land on the home screen of the Groww App.
Now using the Search Option above find your preferred Index Fund or Mutual Fund.
Select the Fund of Your Preference.
Now Invest with either through Lumpsum or ONE-TIME method or through SIP or Systematic Investment Plan method.
Hope by now you have understood the difference between Index Fund vs Mutual Fund. And now you can decide which kind of fund suits your investment style. Still, we would ask our reader to consult with a certified professional before making any investment decision as – Mutual Funds are subject to market risk. Please read all scheme related documents carefully before investing.
And if you have any doubt regarding this article, do ask in the comments below.
Disclaimer: The views, investment tips, presumptions, and calculations expressed on Moneypremier.net are not of the website or its management. This article is for Educational Purpose only. Moneypremier.net advises users to check with certified experts before making any financial decisions.