Index Funds vs Actively Managed Funds – Which is Better?

In the past few years, India has witnessed a significant shift from actively managed mutual funds to passive funds such as Index funds. Experts believe that the rationale behind such a shift is that the idea of actively managed funds outperforming their benchmark is not necessarily true. Thus, investors feel it makes little sense to pay comparatively higher expenses towards actively managed funds, and opting for index-tracking funds can reap greater benefits in the long run.

In this blog, we will highlight the key features of both mutual funds and index funds for investors to make an informed investment decision.

Understanding Mutual Funds

Mutual funds combine the wealth of investors who willingly pool their funds. A fund manager manages the pooled funds on behalf of the mutual fund investors. He/she is in charge of purchasing securities such as stocks and bonds as per the investment aim of the fund. 

Understanding Index Funds

Index funds invest the pooled funds in stocks of the chosen index in the same proportion as the index (Sensex or Nifty). Index funds in India are usually benchmarked to either the Nifty or the Sensex. These are called passively managed funds as the fund manager does not pick stocks based on any portfolio strategy. The index fund manager modifies the index fund portfolio only when the index weights change or if there is an addition or deletion of stocks from the index. An index fund aims to replicate the index returns as far as possible.

Key differences between Index Funds and actively managed mutual funds

Here are some broad differences between index funds and mutual funds:

Index Funds	Actively managed mutual funds
Replicates the performance of the selected benchmark index.	Invests in a basket of securities that are actively traded on the stock exchange.
Passive management style	Active management style
Lower expense ratio as compared to actively managed mutual funds.	Higher expense ratio due to active management style.
Since Index funds are also a  type of mutual fund, their value is determined using end-of-day NAV.	End-of-day NAV is considered to determine the value of a mutual fund unit.
A relatively new form of investment.	Actively managed mutual funds have been around for much longer in the Indian market context.

Choosing Between Index Funds and Active Mutual Funds

Every investor has the choice of either being an active investor or a passive one. So, how are the two different? Here’s how:

    An active investor is ready to take on the risk associated with stock selection to get higher returns. He/she typically prefers to invest in equity diversified funds.

    A passive investor is one who targets lower returns but is unwilling to take on company-specific and industry-related risks. Such investors will choose an index fund or an index ETF.

Since index funds are exposed to market risk, the fund returns may fluctuate depending on overall market performance. Since the composition of the fund is dependent on the index, this risk is mostly unavoidable. Actively managed funds, on the other hand, can limit this risk since the stock selection is manual and stock performance may or may not be influenced by market fluctuations.

The question still remains, how do you decide between actively managed mutual funds vs index funds? How are index funds better than mutual funds and what factors should be considered before making an investment decision? In the below section, we will discuss some relative advantages of index funds over mutual funds.

Some primary reasons investors must select index funds over mutual funds are:

    Portfolio stability: Since the portfolio in an index fund is based on the chosen index, there is less shuffling of stocks within the portfolio. This saves brokerage and transaction costs for investors.    

    Low expense ratio: As the role of fund managers is limited in index funds, the fund management charges are relatively lower. This results in a lower expense ratio than actively managed funds. The estimated average expense ratio of actively managed funds is between 2-2.5%, as compared to 0.5% or lower for index funds.

Drawbacks of Index funds over active mutual funds

For investors who are looking to measure the drawbacks of index funds, here are some important factors to note:

    Since index funds are linked to the performance of the selected index, they may not always beat an actively managed fund that has a good historical performance. Index funds follow the slow yet steady philosophy and may therefore not give short-term gains at all times, which actively managed funds may be able to.

    With an index fund, investors have no control over the fund’s holdings. An index fund may not include a stock or set of stocks that an investor prefers or believes will perform well. Additionally, companies that are not preferred by investors may be included in an index.

    There is no downside protection when it comes to index funds. While an index fund may have proven to be a sound long-term investment, investors will still be at the mercy of the market. When the market swings, so do the index fund returns.

Drawbacks of an actively managed mutual fund

    Mutual funds can underperform the market. Since mutual funds do not follow an index, the composition of the fund depends on the fund manager’s expertise. This can affect the returns generated.

    Mutual funds have comparatively higher fees. Since mutual funds are actively managed, fund managers charge their fees with each adjustment they make to the fund. The extra expense ratio charged on actively managed funds can impact your returns over the long term.

    Mutual fund performance can heavily depend upon the fund selection made by the fund manager. This, in turn, is dependent on his/her experience and knowledge of the markets.

Conclusion

For investors looking to diversify their investment portfolio, it makes sense to invest in a mix of index funds and actively managed funds. For Ex : Index funds could easily replace large-cap mutual funds and investors could choose a well-managed mid-cap or a small-cap fund.  Both these include unique strategies and therefore provide different returns depending on market conditions.