Index Funds Vs Mutual Funds – How to Choose to Invest Actively or Passively
Index funds are a type of mutual fund scheme
A lot of people think that it is index funds vs mutual funds. That is far from true. Index funds are a type of mutual fund scheme. Within the broader mutual fund industry, we have different types of mutual fund schemes that are categorised by SEBI as follows:
- Equity Schemes
- Debt Schemes
- Hybrid Schemes
- Solution-Oriented Schemes
- Other Schemes
Under the category of “Other Schemes”, we have “Index Funds / ETFs” as a sub-category. So, index funds are not separate from mutual funds. Infact, index funds are a type of mutual fund scheme. Mutual fund schemes can also be classified under the categories of active investing and passive investing depending on how the scheme is managed. Index funds fall under the category of passive investing. Before we get into the details of index funds, let us first understand what is passive investing.
Pros and Cons of Index Fund
An index fund has a number of advantages and disadvantages. Some of the most important are listed below.
Pros of an Index Fund
- Low Cost: As they are based on an index rather than being actively managed, index funds are less expensive to own. The fund industry merely repeats the index rather than paying a pricey research staff to find the best choices. As a result, low expense ratios are common in index funds.
- Outperform Active Managers: Although not all index funds are created equal, one of the finest, the S&P 500 Index, in a given year and over time, regularly beats the vast majority of investors.
- Lower Taxes: Index funds that are also mutual funds may result in a lower tax burden for investors due to their lower turnover. This is largely irrelevant in the case of index ETFs.
- Shows Diversification: Index funds can provide the benefits of diversification by combining a number of assets, lowering your risk as an investor.
Cons of an Index Fund
- Might track a Poor index: As previously said, not every index fund is created equal, and an index fund that tracks a substandard index may deliver poor returns to investors.
- Delivers average return: An index fund allocates the weighted average return of the assets. It is unable to avoid the losers because it must invest in all of the index's equities. So, although it may have had exceptional years, a barnburner is unlikely.
Pros and Cons of Mutual Fund
A mutual fund can have a number of advantages and disadvantages. Here are a handful of the most important ones.
Pros of a Mutual Fund
- Likely to be at Lower Cost: Although index mutual funds may be less expensive to buy than comparable index ETFs, many mutual funds are actively managed and thus more expensive.
- Provides Diversification: Whether sector-focused or broadly invested, a mutual fund can give you the benefits of diversity, such as lower volatility and risk.
- Likely to surpass Market: Mutual funds that are actively managed may outperform the market sometimes drastically, but research shows that active investors seldom exceed the market over time. If it is an index mutual fund, however, it will closely track the performance of the index.
Cons of a Mutual Fund
- There's a chance you'll have "lots" of sales: A sales load is a fancy term for a commission, and the worst funds may impose a sales load of up to 3% of your investment, decreasing your profits even before you invest a penny. You can simply avoid these fees by choosing the right fund.
- May have a higher cost ratio than an ETF: Even with all the analysts required to filter through the market, an actively managed mutual fund will most likely have a higher expense ratio than an ETF.
- Likely to Outperform Market: Active management, which is more common in mutual funds, has a history of underperforming the market.
Capital Gains Distribution: At the end of the year, mutual funds may be obligated to distribute certain capital gains for tax reasons. You may be responsible for taxes even if you did not sell a share of your mutual fund.
What is passive investing?
Passive investing is an investment strategy in which one buys and holds for the long-term. There are no or minimal transactions of buying and selling of securities in the portfolio. The aim of passive investing is to earn market returns and not to outperform the market. With passive investing, you can build wealth gradually. It is similar to running a marathon rather than a 100 metre sprint.
The advantages of passive investing include:
- Low cost: Passive investing involves investing in a fixed basket of securities in specific proportions with minimal changes. Hence the cost of passive investing is low.
- Diversification: As you invest in a basket of securities, you benefit from diversification which is one of the core principles of investing.
- Transparency: Information related to the constituents of the securities basket and their weightage is public and can be easily accessed by anyone.
- Market returns: Your wealth grows gradually as the market grows over time.
- Tax efficiency: As the strategy involves ‘buy and hold’ for the long-term, the annual short-term capital gain and tax on it does not arise.
Passive investing through index funds
After reading the above advantages of passive investing, you must be wondering how you can benefit from it. One of the best ways of doing it is to invest in index mutual fund schemes.
An index mutual fund scheme is an open-ended mutual fund scheme tracking/replicating an underlying index. As per SEBI guidelines, an index fund should invest at least 95% of its total assets in the securities of the underlying index. Index mutual funds invest in all the constituents of an index like Sensex or Nifty 50 in the proportion of their weightage in the index. In short, an index mutual fund scheme mirrors the performance of the underlying index that it is tracking. The NAVs of index funds go up or down corresponding to the rise or fall in the levels of the underlying index.
Performance of index funds
Let us understand the performance of index funds with the help of an example. Let us consider Motilal Oswal Nifty 50 Index Fund which is an index fund that has the Nifty 50 Index as its underlying investment. We have understood the advantages of passive investing. Let us put them in perspective with regards to the Motilal Oswal Nifty 50 Index Fund.
- Low cost: The Motilal Oswal Nifty 50 Index Fund has a very low expense ratio of 0.10% for the direct plan and 0.50% for the regular plan. This expense ratio is very reasonable as compared to that of active mutual fund schemes that can have an expense ratio upwards of 1.5%. If both the funds give similar returns before factoring in the expense ratio, then the difference of 1% in the annual expense ratio can make a big difference of lakhs of Rupees in the final corpus that you will accumulate with your SIP (systematic investment plan) investments over a long period of 20-30 years.
- Diversification: The Motilal Oswal Nifty 50 Index Fund invests the investors’ money across a diversified basket of India’s 50 largest companies. These companies represent more than 60% of the total market capitalisation of Nifty 500 companies. The companies represent more than 10 different sectors and no single company has a weightage of more than 11%. The fund provides the best possible diversification that you will want.
- Transparency: The Motilal Oswal Nifty 50 Index Fund tracks the Nifty 50 index. The Nifty 50 represents India’s 50 largest companies. All information about these companies is available on their respective websites, BSE and NSE filings, Ministry of Corporate Affairs website, other Government websites, media channels that cover them, and many other sources. All the information is available in a very transparent manner and can be accessed easily by anyone.
- Market returns: The historical performance of the Nifty 50 Index has been good.
As can be seen from the above diagram, Rs. 100 invested in the Nifty 50 Index in February 2006 has multiplied to more than Rs. 550 as of February 2021, resulting in a gain of more than 5.5 times. As the overall market index has historically given good returns, investment in Nifty 50 index mutual fund schemes would have yielded similar returns during the same period.
As the investment strategy is to buy and hold for the long-term, there will be no short-term capital gains tax. The long-term capital gain (LTCG) tax will arise on the long-term capital gains (LTCG) at the time of redemption. However, you can reduce the impact of the LTCG tax by using tax harvesting. If you book LTCG of Rs. 1 lakh every year by selling your mutual fund scheme units and buying them back again, you will save a net tax of Rs. 10,000 (10% LTCG tax on Rs. 1 lakh LTCG) every financial year.
Investing in index funds is on the rise
In India, a lot of investors are now embracing passive investing by investing in index mutual fund schemes. A lot of mutual funds are offering a lot of index mutual fund schemes and ETFs with various underlying indices. The index funds are offered with various underlying indices across:
- Market capitalisation categories (Nifty, Nifty Next 50, Midcap 150, Smallcap 250, Nifty 500 indices),
- Sectors (Bank Index),
- Fixed income (5-year G-sec ETF) etc.
In developed markets like the United States, passive investing has already garnered a large share of investor money as historical data is showing that active fund managers are finding it difficult to generate alpha. In India also, passive funds are garnering more AUM with every passing year. With improving market efficiency, it will be challenging to generate alpha in the future. Hence, investing in low-cost index mutual fund schemes and ETFs will make sense.
Whether You Should Invest In Funds Actively Or Passively?
Active management, whether by experts or by private investors, almost always leads to underperformance. Passive investing appeals to most investors since it requires less time, attention, and analysis while yielding higher returns.
If you invest in an actively managed mutual fund, you should trust the manager to execute his or her job. If you're trading in and out of the fund, you're second-guessing skilled investors whom you've essentially hired to invest your money. That doesn't make logic, and if the fund is held in a taxable account, it could result in capital gains taxes and early mutual fund redemption fees.
Passive investing has already attracted a big share of investor money in developed countries such as the United States, as historical evidence shows that active fund managers are struggling to produce alpha. Passive funds are also gaining greater AUM in India with each passing year. It will be more difficult to earn alpha in the future as market efficiency improves. As a result, investing in low-cost index mutual fund schemes and exchange-traded funds (ETFs) will make sense.
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Q1: Is it possible for an index fund to be a mutual fund?
A1: A mutual fund or exchange-traded fund (ETF) that tracks or matches the components of a financial market index, such as the Standard & Poor's 500 Index, is known as an index fund (S&P 500).
Q2: Is it true that mutual funds make more money than index funds?
A2: While mutual funds are actively managed by an investment professional, index funds are more passive, making them an excellent choice for investors who wish to sit back and wait for consistent returns. Fees on mutual funds are substantially greater than on index funds, which might reduce your potential gains.
Q3: Is it a smart idea to invest in index funds?
A3: Investing in index funds has long been thought to be one of the wisest financial decisions you can make. Index funds are inexpensive, provide diversification, and produce strong long-term returns. In the past, index funds have outperformed other types of actively managed funds by major financial firms.
Q4: Is it better to put money into an index fund or a professionally managed fund?
A4: Compared to actively managed mutual funds and exchange-traded funds, index mutual funds and exchange-traded funds perform better for investors. An active fund costs around five times as much as an index fund for the ordinary investor. After costs, this makes it more difficult for active funds to outperform index funds.
Q5: Are index funds handled in a passive manner?
A5: That's why many people put their money into funds that don't strive to outperform the market. These are index funds, which are passively managed funds. Instead of exceeding their benchmarks, passive funds strive to emulate their performance.