As an investor, you have a wide range of options to choose when investing your money. Two popular choices are mutual funds and index funds, each having distinct features and investment strategies. This article tries to explore the differences between mutual funds and index funds, including their investments, strategies, costs, and factors investors should consider before selecting the approach that best aligns with their financial goals.
Mutual funds:
Mutual funds are investment vehicles that collect money from multiple investors to create a diverse portfolio of stocks, bonds, or other securities. These are actively managed, and fund managers regularly analyze market conditions, conduct research, and make investment decisions. The fund’s main objective is to maximize returns and outperform the market or a benchmark. This hands-on approach usually involves higher fees, as investors pay for the expertise and research efforts of the fund manager.
Mutual funds also offer diversification by investing in various securities, which mitigates risk by offsetting poor performance in one holding with better-performing assets in the portfolio. Investors have access to different mutual funds that serve investment goals such as equity funds, debt funds, balanced funds, and sector-specific funds.
Index Funds:
Index funds are a type of investment fund that follows a passive investment strategy. Unlike active management, these funds aim to replicate the performance of a specific market index, such as the Nifty 50, NASDAQ100, S&P 500, etc. The objective of index funds is to mimic the composition and weightings of the chosen index, offering investors broad market exposure without the need for frequent adjustments in portfolio. Index funds are an excellent option for those looking for a low-cost and straightforward investment strategy.
Index funds are cost-effective due to minimal management and research expenses. They have lower expense ratios compared to actively managed mutual funds, leading to higher net returns over time. These passive funds provide broad exposure to a specific market segment, making them suitable for long-term and diversified investments.
Mutual Funds vs Index Funds:
Mutual funds and index funds are two types of investment vehicles that differ in the following ways.
Management and Costs:
Actively managed mutual funds rely on the expertise of fund managers to make investment decisions that are aimed at outperforming the market. The active management incurs costs, resulting in higher expense ratios for mutual funds that cover research, trading costs, and salaries of fund managers.
Passively managed index funds seek to replicate the performance of a specific market index without active decision-making. Index funds have lower management fees due to their passive nature. They aim to match an index’s performance, resulting in reduced costs and higher net returns for investors.
Risk and Return:
Mutual funds might offer higher potential returns but also carry the added risk of underperformance due to active management.
Index funds provide consistent and passive investment strategies that mitigate the risk associated with poor stock picking.
Diversification:
Diversification helps to reduce the risk of losses by spreading investments across a range of assets. Mutual funds are known for their diversification benefits. They invest in a variety of securities, reducing the impact of poor-performing stocks or securities on the overall portfolio.
Index funds, on the other hand, offer inherent diversification due to their exposure to the broad market. They provide investors access to a variety of stocks within the chosen index, which further reduces the risk of losses.
Past Performances of Actively Managed Mutual Funds versus Passive Funds:
Several studies and research have shown that most of the actively managed mutual funds consistently underperform their benchmarks. The percentage of funds that beat the markets varies based on market conditions and time period.
US Markets:
Over the last 20 years, only 8.4% of actively managed US stock funds outperformed the S&P 500 index. As per a 2022 study done by S&P Global Market Intelligence, more than 90% of actively managed funds failed to beat the market over the long term. For the last 10 years, only 23.8% of actively managed US stock funds outperformed the S&P 500 index according to another study by Morningstar in 2023.
Indian Markets:
Actively managed funds in the Indian stock markets also share the same fate. A 2022 study by SPIVA India found that over 60% of large-cap equity-diversified funds failed to outperform the Nifty 50 TR index over 10 years. Similarly, a 2023 study by Morningstar India published that over 75% of large-cap equity funds failed to beat the Nifty 50 TR index over 5 years.
Why Passive Funds win over Active Funds:
Actively managed funds often underperform due to the difficulty in consistently picking winning stocks and higher expenses compared to index funds. Nowadays, with the readily available information, stock market is efficient. It is challenging for fund managers to find undervalued stocks.
Index funds simply track a market index and have minimal fees, while actively managed funds have higher expenses. Staff salaries, research and trading costs often eat into returns and make it challenging to outperform the market.
For example, ₹500000 invested for the next 10 years in an Index Fund (TER = 0.15%) with a CAGR of 12% would grow to ₹1625865. Whereas, the same amount invested in a Mutual Fund that is compounded at 12% per year but with a TER of 1.5% will be ₹1422315 after 10 years. The investor would have lost ₹203550 as expenses of fund management.
TER means Total Expense ratio includes all the charges collected by Fund Management from investors.
Conclusion:
It is better for investors to choose index funds over actively managed funds due to their lower fees and higher chance of success. Index funds provide low-cost exposure to a diversified portfolio of stocks. These funds consistently outperform actively managed funds over the long term.
In the short term, some active funds might offer handsome returns and manage to beat the market indices. For example, more than 50% of the actively managed funds performed better than benchmark indices and passive funds in 2023 till now.
Finally, investing in active or passive funds depends on the investor’s patience, risk appetite, and understanding.
You can find more information in the links provided below.
https://www.spglobal.com/spdji/en/research-insights/spiva/
https://www.spglobal.com/spdji/en/research-insights/spiva/#india
https://www.morningstar.com/etfs/active-funds-continue-fall-short-their-passive-peers
https://www.cnbc.com/2022/03/21/why-index-funds-are-often-a-better-bet-than-active-funds.html
https://www.morningstar.com/etfs/actively-managed-funds-measured-up-well-market-rebound
Disclaimer:
I provide the information and my views on the website only to educate new investors and stock market enthusiasts on equity and other market investments. Please consult a SEBI registered financial advisor before making any investments in the stock or commodity markets. In case of any queries, you can contact me on Contact Form or email: shivakumar.lachapeta@valueinvestingonline.in.
