Index funds vs equity funds: Similarities and differences

Mutual funds offer a way for both new and experienced investors to invest in the stock market without directly picking individual stocks. However, there are different categories of mutual funds to consider and even different management styles.
Two popular options among those looking to invest in equities are index funds and equity funds. Both aim to grow your money over time, but they take very different paths.
Understanding the difference between index funds vs equity funds that are actively managed is important for investors to align their portfolio with their risk appetite, investment preferences and long-term goals.
In this article, we will understand the regular equity funds and index funds meaning, compare their strategies, costs, and risk factors, and guide you towards an informed decision.
- Table of contents
- What are equity funds?
- Key aspects of equity funds
- Index funds meaning and features
- Key aspects of index funds
- Key differences between index funds and equity funds
- Suitability for investors
- Important considerations
- Choosing the right investment vehicle: A balancing act
What are equity funds?
Most mutual funds are actively managed – that is, a fund manager is involved in actively designing the portfolio based on their analysis and insights with the aim of outperforming the market in the long term. Equity funds fall under actively managed funds.
Equity funds gather money from multiple investors and invest it in a diversified set of stocks of companies shares listed on stock exchanges. These can include large-cap, mid-cap, and small-cap stocks, depending on the scheme category.
Key aspects of equity funds
- Active management: Fund managers continuously assess market trends, company performance, and economic conditions to make stock picks.
- High risk and high return potential: Historically, equities have delivered higher returns over the long run, though they can be volatile in the short to midterm. Past performance may or may not be sustained in the future.
- Varied risk profiles: Though all equity funds are risky, the risk level depends upon the portfolio composition. Large cap stocks often show relatively lower volatility, while mid cap or small cap stocks are highly volatile. Therefore, large cap funds are typically less volatile than those investing in mid and small cap stocks.
Index funds meaning and features
Index funds are categorised under ‘Other Schemes’ under regulatory guidelines. These funds follow a passive investment strategy. They aim to mirror the performance of a specific market index – such as the Nifty 50 or the BSE Sensex – subject to a tracking error, which is the difference between the fund’s performance and that of the benchmark index.
The fund’s holdings aim to replicate the composition of the underlying index as closely as possible. Rather than outperforming the market through active stock selection and portfolio management, such funds seek to replicate the broader market.
Key aspects of index funds
- Passive management: The fund’s core objective is to track an index.
- Lower costs: With lesser research involved, index funds tend to have reduced expense ratios compared to actively managed funds.
- Market-linked returns: Returns are closely tied to the performance of the tracked index, minus tracking errors and fund expenses.
Key differences between index funds and equity funds
Here’s an overview of the main differences between index funds and equity funds.
Parameter | Index funds | Equity funds |
---|---|---|
Management style | Passive; tracks a benchmark index | Active; fund manager selects stocks |
Cost | Generally lower expense ratios | Typically higher expense ratios |
Return potential | Matches market returns | May outperform or underperform the market |
Risk & volatility | Reflects broader market trends | Can be more or less volatile than the relevant market segment, depending upon the portfolio composition. |
Research required | Less frequent rebalancing | Extensive ongoing analysis |
When choosing between index funds and equity funds, remember that passive index investing involves fewer trades and typically has lower fees, yet its returns mirror the broader market. Actively managed equity funds, on the other hand, rely on in-depth research and frequent portfolio adjustments in their bid to outperform the broader market.
Suitability for investors
Choosing between index funds vs equity funds mostly comes down to investment style, risk appetite, and long-term goals. Let’s see what different groups of investors consider before choosing one.
- Investing knowledge
- Those new to investing may find index funds appealing due to simplicity and lower costs.
- Cost reduction
- Investors who emphasise cost reduction may lean towards index funds to save on expense ratios
- Return potential
- Investors who believe in active management and the value addition of skilled managers might lean toward actively managed equity funds, hoping to surpass market returns in the long term.
- Risk tolerance
- Index funds can carry slightly lower risk because their performance is tied to that of the relevant market segment rather than a fund manager’s stock selection.
- Investment horizon
- Equity funds or index funds tracking equity indices are better suited to long-term goals than short-term ones. Investors with shorter horizons may consider actively managed debt mutual funds or index funds tracking fixed income indices.
Important considerations
The difference between index funds and equity funds goes beyond basic theory. Clarity on their mechanics, objectives, and expense structures helps you manage your portfolio with confidence.
- Long-term effects: Higher management fees mean lower net returns. This may make index funds appealing. On the other hand, actively managed funds seek to offer better long-term returns by potentially outperforming the market.
- Disciplined strategy: Awareness of fund types keeps you focused on long-term goals rather than reacting to short-term news and events.
- Informed diversification: Even if you favour one type, knowledge of both lets you allocate assets astutely to balance risk and reward.
Choosing the right investment vehicle: A balancing act
Selecting between index funds vs equity funds often involves blending these two approaches for a balanced portfolio. Here are some tips to streamline your decision:
- Define goals
- Are you saving for retirement, children’s education, or another milestone? Different goals may require different fund types.
- Gauge risk appetite
- If you seek returns in line with the market, index funds might be suitable. If you aim for market-beating return potential and can tolerate more risk, equity funds could be considered.
- Review fund
- For equity funds, assess how the fund manager has performed across various market cycles. For index funds, examine the tracking error.
- Seek guidance
- When in doubt, consult qualified financial advisors to align your choices with your financial profile and timeline.
Conclusion
In the debate of index funds vs equity funds, no single option suits everyone. Both have advantages and can complement a diversified portfolio. Equity funds have the potential to beat market returns but carry higher costs and risks. Index funds provide a cost-effective and relatively reliable way to track the broader market. Evaluate your risk tolerance, timeframe, and goals. Consider professional advice before investing for a well-rounded investment strategy.
FAQs
What are typical expense ratios for index funds compared to equity funds?
The expense ratio differs from one asset management company to another and there are regulatory limits on how much an AMC can charge, based on their Assets Under Management. Actively managed equity funds typically have higher expense ratios than index funds.
How do index funds and equity funds differ in terms of risk and return?
Index funds track the broader market, offering returns mirroring index performance, subject to tracking error. Equity funds may deliver better returns than the market if the manager picks strong stocks, but also carry higher risk.
What role does market research play in managing index funds versus equity funds?
Index funds require minimal research beyond rebalancing to match the benchmark constituents. Equity funds demand continuous study of market conditions, corporate earnings, and economic factors to select and adjust holdings.
Are there any tax implications to consider when investing in index funds versus equity funds?
Both index and equity funds are subject to the same taxation rates. Capital gains arising from equity-oriented investments held for more than 12 months are categorised as LTCG and taxed at a rate of 12.5% beyond the Rs. 1.25-lakh annual exemption limit. Capital gains arising from investments held for less than 12 months are categorised as STCG and taxed at a rate of 20%. For debt-oriented index funds, the capital gains are added to an investor’s annual income and taxed as per their prevailing income tax slab.
How liquid are index funds compared to equity funds?
Both types are typically available as open-ended schemes, allowing you to redeem units on any business day, although exit loads and processing times can vary.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.