Maintaining a balance between risk and returns is an important skill in mutual fund investing. While investing in a fund, you must be faced with the dilemma of whether you must invest in an actively managed fund like an equity fund or an index fund that is passively managed. While both categories of funds have their own pros and cons, knowing them in advance can help you take more informed investment decisions.
What are index funds and active funds?
Actively managed mutual fund schemes like equity funds strive to outperform the market by aiming to generate higher returns than a specific benchmark index. These funds have the flexibility to quickly adapt to changing market conditions. Actively managed funds have fund managers who can make real-time decisions in the interest of their investors. Index funds, on the other hand, come with their own advantages. They lower the total concentration risk of an investor’s portfolio by helping them diversify their investments. They also strive to replicate the performance of their benchmark indices which is a result that certain actively managed funds fail to produce. Read on to understand the differences between these two types of funds in further detail.
What are the differences between index and active funds?
The following table enlists the key differences between actively managed funds and index funds that are passively managed across various categories. You must consider these differences before investing in any mutual fund scheme (active or passively managed):
| Sr. No. | Category | Actively managed funds | Index funds |
| 1 | Nature | The fund manager of an actively managed mutual fund scheme plays an important role in every investment-related decision. They select securities and timing trades and seek opportunities to outperform the market. | Index mutual funds are passively managed. Their main aim is to replicate the returns offered by the benchmark index without active intervention by the fund manager. |
| 2 | Expense ratio | The expense ratio charged by actively managed mutual funds is generally high. | Index mutual funds charge a lower expense ratio when compared to actively managed funds. This also makes an index fund investment a cost-effective one. |
| 3 | Returns | Active funds generally aim to beat the returns generated by the benchmark index. They generate moderate-to-high returns. | Low-cost index funds, on the other hand, generate moderate returns. Their primary objective is to replicate the returns generated by their benchmark index. Hence, they generally generate lower returns when compared to active funds. |
| 4 | Risk | You may expose your investment portfolio to higher risk by investing only in active funds. Certain categories of active funds like small- and mid- cap funds pose a very high risk to the investor. | Index funds, on the other hand, mitigate the overall risk of the investor’s portfolio. They reduce the risk associated with stock selection. Index funds diversify across a broad range of securities within the benchmark index. |
| 5 | Effort | Investing in an active fund generally requires lesser effort. Since these are actively managed funds, you can benefit from the expertise of an experienced fund manager. | Since index funds are passively managed, you might have to assess the market conditions before investing. Furthermore, these funds do not offer any control related to investments to their investors. All decisions are aimed towards replicating the returns generated by the benchmark index. |
The key to maintaining a balance between risk and returns is to invest a percentage of your investible income in both actively managed funds as well as index funds. If the overall risk of your investment portfolio is high, you can mitigate it by investing in an index fund. On the other hand, if you wish to earn moderate-to-high returns, you can invest a portion of your investible income in actively managed funds like equity mutual funds. You must always research funds online, compare them, and check your future returns by using an investment calculator to earn consistent returns in the long term.
