What is the Difference Between Index Funds and Mutual Funds?

If you are confused between mutual funds and index funds, don’t be. You’re not alone in making this mistake. In fact, a lot of people make this mistake. Some know there is a difference, but cannot pinpoint it out. To others, the two terms are synonymous. Yet others think mutual funds are a fund’s structure and an index fund is the fund’s investment strategy.

The truth is that many index funds are actually structured just like mutual funds, but not all index funds are structured like this. There are many mutual funds that are actually index funds. While an index fund points to a fund that follows a specific market index, a mutual fund refers to a much broader class of investments that have to follow a wider range of strategies.

Sounds confusing? Well, it is. We’re not going to blame you!

In this article, we will show you the differences and similarities between index and mutual funds.

What is a mutual fund?

When you hear of a mutual fund, know that the name refers to the fund’s structure more than the strategy of investment. Mutual funds combine the funds of its investors who pool their money mutually to buy and sell various market securities.

Investing in this type of fund is not about trading shares of companies held by mutual funds. Rather it is about buying and selling shares of the mutual fund company itself. The mutual fund investors buy and sell their stakes at prices set at the very end of the trading session. Value of these funds do not fluctuate over the trading session.

What is an index fund?

Index funds refer to a fund’s investment strategy and not the structure. Such funds aim to match a market index’s performance. Index funds are not managed by a fund manager. This fund seeks not to beat the market but to match the market’s performance.

These funds can be structured like a mutual fund or even as an Exchange Traded Fund. Unlike mutual funds though, ETF values fluctuate over a trading session. While mutual fund investors do business with the fund company itself, investors of the ETF do business with other investors in buying and selling shares of the ETF.
What are its differences?

Apart from the differences mentioned above, there are three other more important differences between index and mutual funds. These are the differences that determine all essential decisions about goals, holdings and cost of investing of each fund.

Active and Passive

Most mutual funds are actively managed, but not all. Active management involves the fund manager taking daily and even hourly trading decisions.

Index Funds take a passive approach. These are not managed by a manager since these follow a market index automatically. The aim of index funds is to buy and hold securities which coincide with the following index. Thus, there is no need to buy and sell such securities on a regular basis.

As there is no fund manager for an Index Fund, its performance is based on the price movement of its own shares. In an active mutual fund however the fund managers take all the decisions. They are free to pick securities that meet the objectives and character of the fund.

People debate which is better: the passive approach or the active management approach. However, according to the SP indices, active funds do not necessarily give better results.

Goals

The second difference has to do with the goals of these funds. In Index funds, it is easier to mirror the performance of a market Index. In mutual funds, the main objective is to perform better than the market. These select investments which have a high likelihood of bringing a higher return than the market.

Costs

The cost of running an actively managed mutual fund, or any fund for that matter, is higher. There are many expenses like a fund manager’s salary, office space, bonuses, operating and marketing expenses, and more. These costs are shared and absorbed by shareholders in the Mutual Fund Expense Ratio fee.

There are fees in an index fund too although the cost of running is much lower.

The lower a fund’s management fees is, the more you can get in return in return.

What are Index Funds? - What are the features of an index fund?

Index funds, as defined by SEBI, are open-ended schemes which track or replicate the market’s index. According to SEBI’s guidelines, the minimum investment in such securities needs to be 95% of the total assets.

More about index funds

Index funds are a certain type of mutual fund. Index funds develop their portfolio by tracking the composition of one or more standard market indexes like Sensex and Nifty 50. Index funds invest in both of them, which make up the benchmark index as present in the index targeted. These seek to follow the performance of one or more indexes in terms of their returns at minimal cost. These are called passive funds too since these don’t need a high level of active management. And since there is no need for an active management, it makes index funds more cost-efficient than actively managed funds.

What are the features of an index fund?

• Index funds can be taken as a long-term, less risky form of investment
• The success of these funds predominantly depends on the choice of index and their low volatility
• Since these funds create a portfolio that almost replicates the chosen index, the returns offered by these funds are also similar to that of the index
• Given the dependence of these funds on the performance of an index, index funds are passively managed; hence, these funds are not meant to outperform the market but instead mimic the index’s performance
• Due to the passive management of these funds, they involve lesser expense ratio and thus, low expenses
• Index funds are, additionally, known to provide broad market exposure and low portfolio turnover to the investors

What are the benefits of having an index fund?

There are several benefits in having index funds. These are:

• Low cost: As said before, index funds are passively managed. This means that there is no need for an active management. This makes index funds more cost effective, than let’s say, most other mutual funds. Actively funds may charge you anywhere from 1-2 percent, while passively managed ones charge 0.50% at the most as TER. This cost difference may not seem like much right now, but in the long run, the difference can be as much as 15% of your net returns.
  
  
• Diversification: Index funds are highly sought after because these are made up of securities of the top companies in terms of market capitalization. This means that the following benchmark index will be made up of top companies in the industry sector. Due to such diversification, investors are relatively safer from risks of investing in just one company or industry.
  
  
• No errors: Index funds are not actively managed by a manager, and so there is no room for error.