There are a number of investment options available for you to choose but getting your hands on a suitable one can take some time and effort. Most investors, whose risk profile allows them to choose investments other than life insurance and have a policy may choose to opt for mutual fund investments. However, mutual funds can be a little complex to understand.
For instance, take the difference between index funds and mutual funds. Though these two investment products do have some stark differences, they can appear to be the same instrument for many. Seasoned investors who regularly opt for mutual funds or index funds as their investment vehicle can tell these two products apart – so this a short guide if you are still learning about the differences.
What is a Mutual Fund?
Simply put, a mutual fund investment collects and pools the finances from many investors and then allocates these funds to different securities such as bonds, stocks, and so on. Since an experienced fund manager picks these investments for the mutual fund on behalf of the investors, mutual funds are actively managed funds. Mutual fund units are known as mutual fund shares and can be redeemed and sold at the existing Net Asset Value (NAV) per share as given on the date of redemption.
In a mutual fund, the investment allocation can be diversified between all the securities or also be concentrated on one category of assets, which happens in the case of large-cap funds. When the asset allocation is concentrated in high-risk securities like stocks and other market securities, the mutual fund is said to carry a higher risk.
What is an Index Fund?
The major confusion that many new investors face with index funds is that index funds are actually a type of mutual fund. However, an index fund replicates a market index in terms of the portfolio and asset allocation and, therefore, aims to match the market index's performance. Index funds are relatively new to the Indian market but are catching on fast as investors are learning quickly about all their available investment options.
Unlike a mutual fund, an index fund cannot be customised, and different securities cannot be hand-picked for two main reasons – these are passively managed funds, and the function of the index fund is to mirror a market index and, consequently, match its performance. This is also the reason why there is a chance of a tracking error in index funds, meaning a discrepancy between the index fund performance and the market fund.
Index Fund vs Mutual Fund
Apart from the difference in the definition of these two investment products, here are some more parameters on the basis of which one can differentiate between the two:
- Objective of the Investment:
An index fund invests in the securities that are part of the market index to replicate and match the returns generated by the index. On the other hand, a mutual fund pools in the funds from different investors under a scheme to maximise the returns an investor will receive.
- Management of Investment:
Index funds are passively managed, and no fund manager allocates the funds to different securities. Mutual funds are actively managed by experienced financial professional who chooses the securities and the allocation as per their understanding and knowledge.
- Investment Flexibility:
There is no scope of changing the allocation of the funds or the securities in an index fund as the market index is the lead. Mutual funds offer better flexibility since the fund manager can switch the allocation of securities as per their performance to maximise investor returns.
- Type of Investment:
An index fund can invest in stocks, bonds, and any other securities that are also a part of the market index. The index fund’s composition and asset allocation match the market index it follows. Mutual funds invest in securities chosen by the fund manager and according to the fund’s objective.
The Choice between Index Fund vs Mutual Fund
There is one common factor between index funds and mutual funds – investors who do not want to risk carrying out stock market trading activities by themselves opt for either one of the two or even both options.
Mutual funds can be a suitable pick for you if you are looking for an investment that offers great flexibility in terms of asset allocation and the choice of securities. Before investing in a mutual fund, you can look into the details of the scheme to understand the risk it carries, what type of securities it invests in, the objective of the scheme, and so on. Active fund management strategies employed by the fund manager can enable short-term capitalisation of gains.
Index funds do not offer such an extent of flexibility, but that does not mean investors avoid index funds. It can be a good choice for those who want to steer clear of the risks of actively managed funds. As with any investment, it is advisable to maintain an investment tenure of at least 5 years in an index fund since the market index also highlights stable trends during such a duration. It should be noted that an index fund cannot beat the market index.
If you are an investor who wants to opt for mutual funds or index funds, you should be aware of the objectives and risks of both investment options. Hence, you should secure your investments with some low-risk options like life insurance.
Conclusion
While stock market investments may not be for everyone, there are different ways to benefit from stock market returns. When you invest in a mutual fund or an index fund, you will always be informed of all the direct and indirect risks related to the investment option of your choice so that you can make an informed decision to meet your financial goals.
L&C/Advt/2022/Dec/3338