What distinguishes an index fund from other mutual fund schemes?

 What distinguishes an index fund from other mutual fund schemes?

There are mutual funds that are sector specific, some target only certain market cap, some invest only in a particular asset while some have multi asset allocation strategy. Each mutual fund builds its investment portfolio based on its investment objective and risk profile. For example, a large cap fund manager cannot invest in small cap stocks in anticipation of high risk rewards tradeoff. Many investors prefer mutual funds over other investment avenues is mainly because these are a pool of professionally managed funds that invest in a diversified portfolio of securities.

Asset Management Companies owning mutual funds collect money from investors and invest this capital raised to achieve a common investment objective. Mutual fund investors are allotted mutual fund units in quantum with the investment amount and also depending on the fund’s current NAV (net asset value). The net asset value of company represents the total value of the price per unit of its outstanding shares at which it can be traded at the stock exchange. So, to illustrate this in a simpler way, if you make a lumpsum investment of Rs. 6000 in a mutual fund scheme whose NAV is Rs. 10, you will be allotted 600 units.

Mutual funds can be largely categorized as actively managed funds and passively managed funds. Actively managed funds are those open ended mutual fund schemes which involve active participation of the fund manager.On the other hand, passively managed funds like index funds have fund managers, but they do not have active participation.

What are index funds?

According to market regulator SEBI, “Index Funds replicate the portfolio of a particular index such as the BSE Sensitive index, S&P NSE 50 index (Nifty), etc. These schemes invest in the securities in the same weightage comprising of an index.Index funds are open ended schemes that aim at generating capital appreciation over a stipulated period of time by replicating the performance of its underlying benchmark / index with minimum tracking error.

What are some of the major differences between index funds and other mutual funds?

Although there are multiple similarities between these two, here are some of the noted differences between index funds and other mutual fund schemes –

Parameter Index funds Other mutual funds
Investment objective To achieve capital appreciation by replicating its underlying index with minimum tracking error To achieve capital appreciation by investing in a diversified portfolio of securities and outperforming its underlying benchmark
Invests in Securities of a particular index Asset classes, debt instruments, equity etc. such that it aligns with the investment objective and risk profile of the scheme
Active / Passive management Since there is not active participation of the fund manager, index funds can be categorized as passively managed funds These are actively managed funds where the fund manager is responsible for buying / selling securities so that the scheme is able to achieve its investment objective
Expense ratio Carries a low expense ratio since there is no active involvement Expense ratio is high compared to passively managed funds like index funds

If you are new to investing and unsure about which fund to invest in, feel free to seek professional consultation. A financial advisor might help to make an informed investment decision. Mutual fund investments are subject or market volatility. They do not guarantee capital appreciation. Investors are expected to understand their appetite for risk before investing.

Danny White