Index Funds vs Mutual Funds - Differences and Similarities

In this developing world options for investing are changing faster than ever, and it is important to be updated about various options to make decisions that will help you to efficiently allocate your money to make higher returns. One common confusion among people is whether to invest in an index fund or a mutual fund. Both options may seem the same but how they work is a little bit different, with different costs, and have different risks. It may seem a bit harder to decide which one is the best choice for you to achieve your financial goals, but don't worry, in this article, we will give you a comprehensive guide about the difference between mutual funds and index funds which will help you to select the best one.

What are Index Funds?

An index fund is a type of mutual fund that seeks to follow and mirror the performance of a certain market index such as Nifty50 or Sensex. 

Here, the fund houses collect money from the investors and replicate a particular index by investing in all the stocks in that index as per their weightage. The main objective of this type of fund is to mirror the performance of a certain index. This passive investing strategy enables fund houses to offer greater market exposure as well as diversification across multiple sectors and companies.

An index fund's passive investment strategy helps eliminate the need for fund houses to individually select and manage the stock portfolio, this, in turn, reduces the management fees, which translates into lower expense ratios.

What are Mutual Funds?

In simple terms, a mutual fund investment collects and pools money from many investors and then allocates these funds to invest in different securities such as bonds, stocks, and so on. Experienced fund manager picks the assets for the mutual fund on behalf of the investors, and are actively managed by them.

Mutual funds can be classified into different types based on allocation, such as Equity funds which focus on investing only in equity securities, Debt funds which focus on bonds, and Hybrid funds which will have a combination of both stocks and bonds.

Difference Between Index Funds and Mutual Funds

Mutual Funds vs Index Funds: Similarities

• Professional Management: Both index and mutual funds are managed by financial experts who make decisions regarding the buying and selling of securities on behalf of investors

• Pooled Investment: Both mutual funds and index funds pool money from multiple investors to create a larger corpus, which is then invested in a different portfolio of assets.

• NAV-Based Transactions: Both mutual funds and index funds operate based on a Net Asset Value (NAV), which determines the price at which investors buy or redeem fund units

• Expense Ratios: Both of these funds charge an expense ratio, which is the fee for managing and operating the fund. This fee is typically expressed as a percentage of the fund's average assets under management (AUM)

Advantages and Disadvantages of Index Funds

Advantages

• Lower costs: Index funds generally have lower expenses because they are not actively managed. These lower expenses help investors get better returns.  

• Long-Term Investment: Index Funds are considered ideal for long-term investors looking to reap the benefits of general market growth.

• Simplicity: Index funds investing requires little knowledge about the market because it follows a certain index.

• Transparency:  Because Index funds track a specific index, Investors know exactly which securities the fund holds, making it more transparent.

Disadvantages

• Overexposure to Certain Stocks: Index funds aim to replicate the performance of a specific index, such as the NIFTY 50 or SENSEX, by holding the same stocks in proportion to their weightage in the index. However, this can lead to overexposure to certain stocks which have more weightage.

• No control over holdings: An index fund holds the same stocks and in the same weight that of the index it seeks to replicate or mirror the performance, and the fund manager can not change the composition of the portfolio.

• Limited Potential for Outperformance: Index funds are designed to track a specific market index, like the Nifty50 & Sensex, rather than outperform it. This means you can’t expect returns higher than the market itself.

• No downside protection: Index funds mirror the composition of the index they track, so there is no room for rebalancing the portfolio during a market downturn.

Advantages and Disadvantages of Mutual Funds

Advantages

• Active Management: Mutual funds are actively managed by professional fund managers who make investment decisions based on research, analysis, and market conditions. This gives investors the benefit of expert management without needing to make their own investment choices

• Different Investment Goals: There are various types of mutual funds catering to different investment goals, including growth, income, and capital preservation. You can choose funds based on your risk tolerance, time horizon, and financial objectives.

• Transparency: Mutual funds disclose their holdings regularly, so investors know where their money is invested and how the fund is performing.

• Diversification: Mutual funds invest in multiple sector stocks. This helps in offsetting one sector’s loss by another sector's profits.

Disadvantages

• High Expenses: While debt funds have a lower expense ratio, equity mutual funds often have higher management fees because their active management, research, and frequent trading incur additional costs, which can eat into returns.

• Lack of control: Individual investors will not have any control over which securities to buy or sell, only fund managers can make these decisions.

• Managerial Risk: The success of any mutual fund entirely depends on the skill and expertise of the fund manager. Wrong choices by the manager may result in losses for the investors.

• Over diversification: If a fund invests in many securities to diversify the overall risk, it can also impact the overall return a portfolio might deliver.

Mutual Fund vs Index Fund: Tax Implication

In India Taxation on mutual funds varies based on the type of fund and holding period. As per the 2024 Budget, any mutual fund units sold on or after Jul 23, 2024, will have the following tax implications

• Equity-oriented mutual funds: STCG is liable for 20% in case of holding for less than a year. If the funds are held for over a year, LTCG is charged on gains exceeding Rs.1.25 lakh at 12.5%. 

• Debt-oriented mutual funds: As per the recent budget, the income earned through debt mutual funds shall be taxed as per the tax slab of the respective individuals. Here, the holding period of the debt funds is not taken into account.

• Hybrid mutual funds: For hybrid funds that invest between 35% to 65% in Indian equity, an LTGC is taxed at 12.5% if the fund is held for more than 2 years. For holding periods of less than 2 years, the gains are taxed as per income tax slab rates.

• Index funds: These funds are mainly equity-oriented and follow the same tax rules that apply to equity mutual funds. If the index fund is debt-oriented, the debt mutual fund taxation rules apply.

For more detailed information about tax implications on Mutual Funds, you can read our detailed article on “Tax on Mutual Funds”

Index Funds vs Mutual Funds: Which is Better?

Choosing between an index fund and a mutual fund depends on your goals and financial objectives. Index funds tend to be cost-effective and provide market-aligned returns. In contrast, equity-based mutual funds aim to outperform the market, but they come with higher risks and costs. Debt mutual funds offer stable returns over the years, while hybrid mutual funds attempt to combine elements of both equity and debt investments. Therefore, when deciding between a mutual fund and an index fund, it is important to be aware of your investment objectives and the associated risks of each option.

Conclusion

In conclusion, Both mutual funds and index funds may offer different benefits that appeal to different investors. You have many options and possibilities. Ultimately it all comes down to your goals, risk tolerance, and investment strategy. However, it is important to be aware of all the risks associated with both of these funds.

FAQs

Q. Which is safe, an index fund or a mutual fund?

Index funds are typically safer than equity mutual funds but may have similar or higher risk levels compared to debt funds.

Q. What is one difference between actively managed mutual funds and index funds?

In actively managed mutual funds, managers choose investments and adjust allocations based on research and market trends. This strategy relies on the fund manager's expertise and insights. However, in index funds, managers follow and replicate a certain index by investing in the securities that constitute that index to mirror the performance.

Q. Can I invest in both index funds and mutual funds?

Yes, one can simultaneously invest in both Index funds and Mutual Funds. Ideally, it is better to have a healthy mix of index funds and actively managed funds in your equity portfolio. 

Q. Do mutual funds have better tax benefits than index funds?

Mutual funds have no special tax benefits over index funds. The basis for taxation will depend on whether the fund is equity-oriented or debt-oriented.