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.
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 |
|
Replicates the |
Invests in a |
|
Passive management |
Active management |
|
Lower expense |
Higher expense |
|
Since Index funds |
End-of-day NAV is |
|
A relatively new |
Actively managed |
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.