Index Funds Vs Mutual Funds: What is the Difference?

All index funds are mutual funds, but not all mutual funds are index funds. While both offer diversification and the potential for wealth creation, they adopt rather different strategies and approaches, making each of them suitable for specific investment cases. In this article, we’ll understand the differences between index funds and actively managed mutual funds through relatable scenarios, helping you determine which option aligns favourably with your financial goals.

Table of contents

• What is an index fund?
• What is a mutual fund?
• Differences between index funds and mutual funds
• Which is better: index funds or mutual funds?
• Key features of index funds
• Key features of mutual funds
• How to invest in mutual funds, including index fun

What is an index fund?

An index fund is a mutual fund scheme that aims to replicate the performance of a specific market index, such as the Nifty 50 or BSE Sensex (subject to tracking error). Instead of selecting individual securities based on active research, the scheme invests in the same constituents as the chosen index and in the same proportion. This approach follows a predefined methodology and does not involve active stock selection by the fund manager.

What is a mutual fund?

A mutual fund is a regulated investment vehicle that pools money from multiple investors and invests it in a diversified portfolio of securities such as equities, debt instruments, or a combination of both. Each scheme is managed according to its stated objective, and professional fund managers execute the investment strategy within SEBI’s regulatory framework. Mutual fund units represent an investor’s proportional share of the scheme’s underlying portfolio.

Index funds are also a category of mutual funds and are considered as passive mutual funds since they only aim to replicate the performance of a specific market index. In actively managed mutual funds, on the other hand, the fund manager seeks to potentially outperform the benchmark in the long term through strategic stock selection.

Differences between index funds and mutual funds

Here are the differences between index funds and mutual funds on various parameters:

1.Investment and management style

Index funds (passive)

• Operate on a passive investment strategy, tracking the composition of a specific market index, such as NSE Nifty 50 or BSE Sensex.
• Fund managers primarily ensure the fund portfolio mirrors the index, potentially matching its performance but making no active attempt to outperform it.

Mutual funds (active)

• Active mutual funds employ an active investment strategy, where fund managers make decisions to buy or sell securities.
• Focus on outperforming the market or achieving specific financial objectives.

2.Expense ratio

Index funds

• Have a lower expense ratio because of passive management.
• Costs are limited to maintaining the portfolio in alignment with the index.

Mutual funds

• Active management and associated research increase costs, leading to a relatively higher expense ratio.
• May include additional fees like exit loads and commissions in some cases.

3.Performance

Index funds

• Aim to match the performance of their benchmark index, not outperform it.
• Returns are potentially steady and predictable, reflecting broader market trends.

Mutual funds

• Fund managers seek to outperform the market, which can result in a relatively higher return potential during favourable conditions.
• Performance hinges on the expertise of the fund manager to navigate evolving market dynamics, optimising the return potential and mitigating risk.

4.Simplicity

Index funds

• Simple to understand and invest in, as they track predefined indices.
• Suitable for long-term, passive investors who prefer minimal involvement and a hands-off investment approach.

Mutual funds

• Can be complex due to varied fund types, objectives, and strategies.
• May require more effort to understand and monitor performance.

5.Risk

Index funds

• Have moderate risk, as they mirror the broader market's performance.
• Investors are exposed to market volatility, but the risk is diversified across the entire index.

Mutual funds

• Risk levels can range from low to very high, depending on the fund type.
• Fund managers play a key role in managing risk through different market cycles.

6.Objectives

Index funds

• Designed for investors seeking returns that mirror market performance.
• Can be suitable for long-term wealth creation with minimal intervention.

Mutual funds

• Target specific goals such as the potential for aggressive growth, steady income, or balanced returns.
• Suitable for investors looking for actively managed, goal-oriented investments.

7. Expense ratio

Index funds

• Index funds generally have a comparatively lower expense ratio because they follow a passive strategy that replicates an existing index without active security selection.
• The expense ratio primarily reflects administrative and operational costs, with minimal fund management intervention, which aligns with the nature of passive investing.

Mutual funds

• Actively managed mutual funds usually have a higher expense ratio because fund managers conduct research, analyse securities, and make active decisions to meet the scheme’s stated objective.
• The expense ratio includes research costs, fund management fees, and other operational expenses, which contribute to the difference in cost compared to passive schemes.

8. Performance comparison

Index funds

• Index funds aim to replicate the movement of their underlying index, so their performance generally stays close to the index, subject to tracking error.
• Their long-term outcomes depend on how accurately the scheme mirrors index changes, rather than on active decision-making.

Mutual funds

• Actively managed mutual funds may outperform or underperform their benchmark depending on market conditions, strategy, and fund manager decisions.
• Their performance varies across market cycles, as outcomes depend on security selection and the effectiveness of the investment approach.

Past performance may or may not be sustained in future.

9. Risk factors

Index funds

• Index funds carry market risk because they mirror the underlying index, and they remain fully exposed to broad market movements without any active adjustment during volatility.
• Tracking error is an additional risk, as the scheme’s returns may differ slightly from the index it seeks to replicate.

Mutual funds

• Actively managed mutual funds carry market risk and also active management risk, as outcomes depend on the fund manager’s decisions and investment strategy.
• Their risk level may vary across categories. Equity-oriented schemes carry high risk, while debt-oriented schemes are relatively stable but are still exposed to market risk.

10. Tax implications

Index funds

• Equity-oriented index funds (investing more than 65% in equity) follow the current equity taxation rules.

Mutual funds

• Tax on mutual funds depends on the scheme category: equity-oriented schemes follow equity tax rules, while non-equity (debt-oriented) schemes are taxed as per the investor’s income slab, regardless of holding period, since indexation benefits were removed in 2023.

Pros and cons of index funds and mutual Funds

Pros of index funds

• Expenses may be relatively steady due to passive management.
• Transparent portfolio structure because holdings mirror the underlying index.

Cons of index funds

• Limited flexibility as the fund does not aim to outperform the benchmark.
• Tracking error may affect outcomes over time.

Pros of mutual funds

• Professional research and active decision-making.
• Flexibility to adjust portfolios in changing environments.

Cons of mutual funds

• Expenses may be higher than passive schemes.
• Active decisions may not always achieve the intended outcomes.

Read Also: Mutual Funds vs Stocks: Differences and Which is Better?

Which is better: index funds or mutual funds?

Consider index funds if:

• You prefer low-cost, passive investment options.
• Long-term consistency and market-aligned returns are your objectives.

Consider actively managed mutual funds if:

• You are comfortable with relatively higher costs and volatility in a bid to outperform the market.
• You seek a tailored investment strategy for specific financial objectives.

Key features of index funds

• Limited choice for investors compared to actively managed mutual funds.
• May suffer from tracking error if fund fails to accurately replicate the performance of the underlying index.
• Easy to track due to fixed portfolio composition but less flexible to respond to market changes.

Key features of mutual funds

• Wide variety of funds catering to different goals such as growth, income, or balanced objectives.
• Potential to outperform the market under favourable conditions.
• Include equity, debt, hybrid, sectoral, and thematic funds.

How to invest in mutual funds, including index fun

• Set your financial goals: Identify your investment objectives, risk tolerance, and time horizon.
• Research fund options: Evaluate funds based on performance history, expense ratio, and ratings.
• Complete KYC (know your customer): Submit required documents like PAN and Aadhaar for identity verification.
• Choose an investment platform: Use fund websites, brokerage platforms, or contact a distributor.
• Decide investment type: Opt for a lumpsum or Systematic Investment Plan (SIP) depending on your budget.
• Monitor performance: Regularly review your portfolio to ensure it aligns with your goals.

Read Also: Index vs Equity Funds: Meaning, Differences & Which One to Choose

Conclusion

The debate of index funds vs mutual funds boils down to your investment style, risk appetite, and financial goals. Index funds provide a low-cost, low-maintenance option for market-aligned returns, making them suitable for long-term passive investors. On the other hand, actively managed mutual funds offer flexibility, variety, and the potential for higher returns, making them suitable for those comfortable with active management and relatively higher associated risks.

FAQs:

Are index funds better than mutual funds?

It depends on your goals. Index funds may be suited to low-cost, market-aligned investing, while mutual funds may be more aligned to a higher return potential through active management, albeit at a relatively higher risk.

Which is riskier: mutual funds or index funds?

Mutual funds can be relatively riskier due to the active management style, which places the onus of risk mitigation on the fund manager. On the other hand, index funds carry moderate risk aligned with broader market performance.

What is the difference between passive and active mutual funds?

Passive funds replicate an index and aim to mirror its performance, while active funds involve a fund manager selecting securities. Passive funds typically have lower costs but still face market risk. Active funds may offer different strategies but also carry the risk of underperforming their benchmark.

Do index funds carry the risk of tracking error?

Yes, index funds may experience tracking error because their returns may not match the benchmark exactly. Factors such as expenses, cash holdings, and execution delays may cause this gap.

Which is better for long-term investing, index funds or active mutual funds?

Neither option is inherently ‘better’, as suitability depends on an investor’s goals, risk appetite, and investment horizon.

Are there different types of mutual funds besides index funds?

Yes, mutual fund types include several equity funds, debt funds, hybrid funds, sectoral and thematic funds, fund of funds, and solution-oriented categories. Each category follows SEBI-defined mandates and carries different risk levels.

How frequently should I review my mutual fund or index fund investments?

A periodic review, such as once or twice a year, may help assess whether the fund continues to align with personal goals and risk tolerance. Reviews may consider portfolio changes, performance against relevant benchmarks, and evolving financial needs. Frequent changes are unnecessary unless long-term suitability or asset allocation has shifted meaningfully.

What tax benefits do ELSS mutual funds offer compared to index funds?

In the old regime, ELSS funds qualify for deductions of up to Rs. 1.5 lakh in taxable income in a financial year under section 80C of the Income Tax Act, 1961, under the old regime. They are equity-oriented and carry high risk. Index funds do not offer any such deductions. Capital gains are subject to tax under prevailing tax laws.