Index Funds vs Mutual Funds: Know the Difference

May 31, 2023 Mutual Fund

Passively managed mutual funds, such as Index Funds, have gained a firm footing among investors in the last couple of years. In this article, know about the difference between Index Funds and active mutual funds.

What is an Index Fund?

Index Funds are passive mutual funds that generally track popular indices such as Nifty 50, S&P BSE Sensex, Nifty 500, etc. Index Funds are mandated to invest a minimum of 95% of their total assets in securities that form part of the underlying index. A small portion of the fund can be held in cash and equivalents to meet the liquidity requirement under the scheme. The stocks and their weightage in the portfolio of an Index Fund are similar to that of the underlying index. The composition of the scheme’s portfolio is altered only if the stocks and their weightage in the underlying index change. Accordingly, the portfolio turnover of an Index Fund is very low.

Being passively managed, the expense ratio of Index Funds is significantly lower than actively managed funds. Furthermore, investing in an index fund eliminates the risk of stock selection arising from any potential behavioural bias/judgement errors of the fund manager.

Another benefit of investing in an Index Fund is that investors do not have to go through the challenging task of selecting the best mutual fund from the plethora of actively managed funds available, as all funds tracking a particular index behave in the same way.

Index Funds vs Mutual Funds:

The key difference between Index Funds and Mutual Funds is in terms of their portfolio management style, objectives, costs, investment style, and the kind of returns they can generate.

1. Portfolio:

Index Funds invest in specific stocks and other securities that form part of an index mimicking its composition. Whereas active mutual funds invest in securities that the fund manager chooses based on the investment mandate of the scheme as well as the prevailing market conditions.

2. Investment Objective:

The Index Funds aim at matching the performance of the benchmark index, as they simply replicate the portfolio of the respective index. On the other hand, active mutual funds aim to outpace the performance of benchmark index by following an active portfolio management strategy.

3. Management Style:

Index Funds are passively managed. The fund managers simply pick securities of the index in the same weights as the underlying index. Whereas active mutual funds use various investment strategies such as value, growth, or blend of both for selecting equities, as well as accrual or duration strategies in the case of debt mutual funds depending on the type of scheme, investment mandate, and the overall market conditions.

4. Expense Ratio:

Index Funds do not need fund managers’ active participation, and hence, the expense ratio of these funds is comparatively lower than active mutual funds. Actively managed mutual funds, on the other hand, involve active participation by the fund managers in doing industry research, selecting the right securities, timing the entry/exit points in the underlying securities, etc. Hence, the expense ratios of active mutual funds are relatively higher.

5. Performance:

As mentioned earlier, Index Funds only replicate the portfolio of popular indices. Therefore, the performance of these funds is closely aligned with that of its benchmark index, subject to tracking error and expense ratio. A tracking error is the difference in returns between an Index Fund and the index which it is tracking. Whereas the performance of active mutual funds can vary significantly compared to that of the underlying index as the fund managers may churn the portfolio and have an overweight/underweight position in different stocks/sectors compared to the underlying benchmark index.

Which are the types of Index funds?

1. Market-based Index Funds

There are Index Funds that track indices that are weighted by their market capitalisation. For instance, the Nifty 50 Index, the NIFTY Midcap 150 Index, NIFTY Smallcap 250 Index, and the Nifty 500 Index, etc.

2. Factor-based Index Funds (Smart-beta Funds)

The stock selection and weights are based on pre-defined factors like value, momentum, quality, low volatility etc. Most Smart-beta funds consist of a single factor, such as the Nifty 100 Quality 30 Index, Nifty 50 Value 20 Index, Nifty 50 Equal Weight Index, etc. In addition, some multi-factor Index Funds replicate an index that uses a mix of two or more factors, for instance, the Nifty Alpha Low Volatility 30 Index.

3. Sector/Theme-based Index Funds

These invest in businesses operating within a particular industry, sector or theme, such as Banking, IT, Pharma, Infrastructure, Manufacturing, MNC, etc. Sector/theme-based index funds track sectoral indices like the Nifty Infrastructure Index, S&P BSE Healthcare Index, S&P BSE Financial Services, Nifty Banking Index, Nifty MNC Index, etc.

4. International Index Funds

These funds aim to track popular offshore indices such as the S&P 500 Index, NYSE FANG+ Index, NASDAQ-100 Index, etc.

5. Debt Index Funds

Debt-based Index Funds track custom debt indices like CRISIL IBX 60:40 SDL + AAA PSU Index – April 2025, Nifty G-Sec Sep 2032 Index, CRISIL IBX AAA Mar 2024 Index, etc. that have varying maturities and credit profiles.

This article first appeared on PersonalFN here