What is an Index fund?
Before explaining the working of the Index fund first I would like to mention, what legendary investor Warren Buffet thinks about the Index fund. “A low-cost index fund is the most sensible equity investment for the great majority of investors,” these are the words of warren buffet about index funds. With this, you probably may have got an idea about how important is an index fund. The major reason why index fund is gaining popularity due to the feature of less hassle in research and good returns.
Index fund tries to mimic the benchmark index they are following. Say if you are buying an index fund based on nifty 50 then all the stocks will be bought in according to the weightage of 50 stocks. Suppose if Reliance weightage is 20% in nifty 50 then in our index fund from the total investment 20% will be invested in reliance like this investment are made in an index fund. For this reason Index funds are called passive funds. Because there is no need for fund managers to adjust our portfolios.
What is an Active fund?
Fund managers try their best to get higher returns than their benchmark index. You may have heard the term ‘Alpha’ in the mutual fund’s terminologies. So Alpha measures the performance of the active fund with the benchmark index. Suppose an active fund has a positive alpha of 3, which means it getting 3% higher returns than the benchmark index. Similarly, if the Alpha is -3 then it is giving -3% returns than the benchmark.
While choosing active funds it becomes of utmost importance to look for the fund manager’s past performance. It all depends on the fund manager and their research, which stocks they will choose and when will sell, they are very active in trading to outperform the benchmark and maintain higher returns throughout the year. That’s why the cost of maintaining the active funds is also high.
Key Difference between Index Fund and Active Fund
|Index Fund||Active Fund|
|Follow the benchmark index||Try to outperform the benchmark index|
|Low expense ratio||High expense ratio|
|Don’t require an active fund manager||Require an active fund manager|
|More tax-efficient||Less tax efficient|
|Returns equal to the benchmark index||Can expect much higher returns than the benchmark index|
Where should I invest?
It all depends on whether you are risk-averse or tolerant. If you are happy with the benchmark performance and don’t want to take more risk then you should go for an index fund. By choosing an index fund you will have to spend less on expensive ratios and get desired returns. But there is a catch in the index fund. The index doesn’t always move exponentially there are times when it will remain in a consolidation phase for a long time. That can go against your expectation of good returns. So make sure if you are going for an index fund keep a long duration investment horizon for good returns.
If you are risk-tolerant then definitely go for active funds. Agreed that here expense ratios are high compared to the index fund, but a good fund manager will give much higher returns than the benchmark. Suppose if the market is negative but the fund managers had the idea to choose securities that will even perform or give better returns than the index.
How to Invest in Mutual Fund
- Decide your risk tolerance
- Decide the type of funds that will suit you
- Choose a good Asset management company
- Choose their plan and look past records of the fund finger
- Do the required KYC online or offline whichever suits you
- Start investing
Pros and Cons of Index fund
- Low cost
- Less risk
- Good diversification
- Can miss big profit opportunities due to high dilution
- If there is sudden volatility in the market, index funds can face a huge loss than active funds.
- Limited options to invest, only stocks that are included in the index calculation.
Pros and Cons of Active funds
- Can expect higher returns compared to the benchmark index
- Less dilution
- During high volatility fund managers can hedge positions
- High fees
- Riskier compared to an index fund
- Less tax efficient
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