One of the key reasons for investing you money through mutual funds is to benefit from the expertise and experience of professional fund managers, who are responsible for making wise investments based on market movements and trend analysis. However, if you do not wish to avail the services of a fund manager, index funds could be a good alternative.
Here is how it works:
For an actively managed fund, the fund manager handpicks the best stocks, bonds and other securities that have the potential to fulfill the scheme’s objectives. The fund manager closely monitors his portfolio and takes timely decisions to ensure best returns. However, this comes at a cost and some amount of risk associated with the fund manager himself.
On the other hand, index funds (also called passive funds) are equity funds that mirror a particular index (e.g. BSE, NSE, etc.) and invest in the same stocks (in the same proportion) as that index. For example, if you invest in an index fund that mirrors the BSE index, you will indirectly invest in the 30 underlying scripts that make up the BSE index. Index funds have no fund manager or a scheme objective.
A Comparative Study
1. Cost of Investments – The cost associated with the management of an index fund is much lesser than that of a managed fund, which requires active trading (churn). Hence, index funds save on expenses like brokerage and transaction costs.
Moreover, since a fund manager is not involved, the fund management charges are lower and hence the expense ratio is lower. The average expense ratio of actively managed fund is 2-2.5%, while it is 1-1.5% in case of index funds.
2. Management Style – An experienced fund manager, following a structured investment approach is like a visionary leader marshalling his resources. Based on the real-time developments and trend analysis, he or she can take strategic decisions that can lead the fund towards outperformance. This aspect is missing for a passive fund.
3. Limited downside – Unlike index funds that mirror the market, managed funds invest in handpicked securities. A fund manager has the freedom to limit the downside by holding only performing securities. In case of index funds, they fall as the market falls.
4. Fund Manager Risk – There is a chance your fund manager might make a poor decision. He might have an in-favourable fund picking style, or might be subject to some form of systemic pressures or might end-up invest in an underperforming stock. There is a chance of him quitting the fund too. These situations can affect your investments. Index funds negate this risk by passively investing only in securities that represent a particular index.
5. Traded on exchanges – Most mutual funds can be traded only on NAV (i.e. the net asset value declared at the end of the day). However, since index funds are traded on exchanges, one can buy and sell them at anytime and take advantage of the real-time prices.
Performance