Mutual funds are a very convenient investment option. If you decide to invest manually, you will have to pick stocks according to your goals and risk appetite, time your investment to take the best advantage, and monitor your investment portfolio now and then. Mutual funds make this easy as a fund manager takes care of your investment.
But choosing what mutual fund to invest in could be a chore, especially given the many choices.
Among the options, an index fund is a choice for many. But what is an index fund, and how is it different from regular mutual funds? Let us find out.
What is a mutual fund?
A mutual fund is an investment option that lets you invest in a prebuilt portfolio according to your investment goals and risk appetite. The fund manager plays a vital role in the case of most mutual funds. They are equipped with the part of designing the portfolio of the fund, ensuring the fund stays valid to the theme at all times, and finally, pooling money from different investors to invest in the portfolio.
The above statement is more true in the case of active mutual funds. Active mutual funds are those where managers play an integral part in deciding the portfolio choices of the fund. Since the role of a fund manager is more critical, the expense ratio, which is a fee charged on the investment to compensate the fund manager, could also be higher.
The opposite of active funds is passive funds. Passive funds have a portfolio that a fund manager does not regularly manage. It usually tracks an already existing composition, like a stock market index. But then, how is the portfolio formed?
Index funds into that category of passive funds. Let us learn more about it.
Index funds are a type of mutual fund. They are passive funds. It means that there is no active role for a fund manager; instead, it follows a preset composition.
Index funds, as the name suggests, track a stock market index as it is. Stock market indexes follow the top stocks of the stock market or a particular sector to track the overall performance of the market or the industry it follows. In simple words, the progress of an index is similar to the progress of the market or industry it follows.
In the case of an index fund, the composition of the fund will be the same as the index it follows. For example, if the index fund tracks Sensex, the fund’s portfolio will be the same as Sensex’s composition. Whenever there is a change in the index composition, the index fund’s portfolio will also change.
Index funds and mutual funds – the differences
The main difference between a mutual fund and an index is that an index fund is a type of mutual fund. As said above, an index fund is a passive fund with the fund manager not having much role in the management. But both passive and active funds come under the wider umbrella of mutual funds.
Investing in index funds comes with many advantages. To begin with, since the fund is passively managed, the expense ratio of the fund is low. This is because the fund manager doesn’t have an active part in managing the portfolio. Secondly, due to the same reason, the portfolio choices are free of any bias.