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There are many investment opportunities available in the financial market for investors to choose from. This also includes various types of funds including mutual funds and index funds. Both are suitable for long-term wealth creation. In this article, let us have a look at mutual funds and index fund meaning, their characteristics and understand the difference between mutual fund vs index fund.
What are mutual funds?
Mutual funds are a type of financial vehicle that pools money from different individuals to invest in a portfolio of stocks, bonds, and other assets.
When investors buy a unit of the mutual fund, they become entitled to the income and the capital gains of the fund in proportion to their fund allocation. The funds are managed by dedicated fund managers who look after the portfolio and work to achieve the expected returns. Mutual funds are often actively managed by fund managers.
What are index funds?
Index funds are another investment opportunity that can be understood as a passively managed mutual fund that tracks the performance of specific market indices like Sensex and Nifty 50.
The index fund mirrors the movements and the returns of the underlying index. They are the ideal choice for investors looking for long-term passive investment strategies with lower costs.
Comparison between mutual fund vs index fund
With an understanding of what index fund vs mutual fund mean, let us look at the factors that differentiate them:
- Investment management
The first factor in index funds vs mutual funds is investment management and its cost and performance. Index funds are best suited for investors looking for a passive investment as they require minimal intervention from the fund manager. This also translates to lower management fees and expense ratios. Additionally, there is portfolio diversification across securities that allows investors to reduce their risk.
As against this, mutual funds are more actively managed to outperform the market which leads to higher management fees and expense ratios. But mutual funds also come with higher returns and are suitable for investors who are willing to take more risks.
- Expense ratio
The annual fee that a fund manager charges for managing the funds is known as the expense ratio. The expense ratio is directly proportional to the time and effort demanded by the financial security. Apart from these fees, the expense ratio also includes other expenses associated with managing the fund.
Lower expense ratios reduce the expenses of the investors and ultimately help them with better returns. Mutual funds have a higher expense ratio because they demand relatively more intervention from the fund manager because of being an actively managed fund. However, the higher expense ratio for mutual funds is worth it because it also comes with higher rewards on investments.
- Performance
The index fund performance traces the market’s overall performance because they are invested in all the securities of a fund. Instead of outperforming the market, index funds aim at mirroring the market. These funds have long been reputed to deliver good long-term returns to investors owing to their passive investment strategy.
On the other hand, mutual funds aim to outperform the market. However, there can be lower returns in case the decisions made by the fund manager do not work in your favour. This can lead to a reduction in the returns due to high expense ratios as well. Index funds have mostly outperformed mutual funds in their long-term performance owing to their low expenses and passive investment strategy combined.
- Simplicity
The index funds are straightforward because the funds mirror the market performance and the investment decisions are predetermined. The investors can easily determine how their investment is positioned and there is very little requirement to monitor and adjust the funds.
As against this, mutual funds function on a more complex investment strategy and a larger portfolio turnover. This adds to the tax implications and also the expenses. Additionally, more analysis and research are required by investors thoroughly analysing the investor’s decision-making process, record, etc.
- Investment risk
It is crucial to consider investment risk when considering the best choice between mutual funds and index funds. The risk associated with index funds is lower than mutual funds as the investment is diversified in different securities to spread the risk.
However, mutual funds have a relatively greater investment risk since the fund managers aim at outperforming the market.
- Active and passive management
This is yet another consideration when deciding the ideal investment type. While mutual funds are actively managed and also provide better returns, index funds are passively managed. The kind of investment type the investor is seeking determines which is the ideal choice.
Conclusion
Both index funds and mutual funds are good investment choices that come with different features. The best choice between the two funds depends on what type of investment the investors are seeking. If they wish to have a long-term reward with lower risks, and a low expense ratio then index funds are the right choice. As against this, for investors looking for quick returns and are willing to take risks, mutual funds are the right choice.
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FAQs
The returns on equity funds are based on how well the investment is managed. If the stocks constituted in the portfolio perform well then so does the fund. As against this, index funds are a representation of the stock market itself and mirror the overall market performance.
The different types of index funds include equity, dividend, growth, bond, commodity, international, value, small-cap and mid-cap index funds.
Index funds differ from mutual funds in that they have a lower risk and lower expense ratio associated with them and provide larger long-term returns. ETFs are more liquid and cost-effective funds because they trade on exchanges such as stocks.
Index funds are a type of mutual fund that have a portfolio and provide a wide market exposure and low portfolio turnover.
Index funds are a safer long-term investment opportunity that also comes with lower expense ratios.