Index Funds VS Actively managed mutual funds, what should you choose and why?
Imagine being on a road trip with two friends. One prefers safety and wants to follow the map, while the other insists he knows a faster route from experience. Both approaches sound reasonable, but unexpected traffic or roadblocks can change everything. A map updates in real time, while memory relies on past knowledge.
Index funds and actively managed funds work in a simpler way. One follows the market systematically, while the other relies on a fund manager’s decisions to try and beat it.
In this blog, we’ll break down the difference between index funds and actively managed funds, how they are managed, what they cost, and which option may suit your investment goals best.
Let’s begin by understanding the basics:
Table of Contents
What are Index Funds:
Index funds are passively managed investment funds, aka exchange traded funds, that aim to mirror the performance of a benchmark rather than trying to outperform it. By investing in the same securities that make up the underlying index and in similar proportions, they provide broad diversification, lower costs and a more stable and predictable investment experience.
What are Actively Managed Funds?
Actively managed funds are investment portfolios that are actively managed by through research, analysis and tracking of market timings, aiming to outperform a specific benchmark index. It involves active decision making, higher fees, and flexibility as a manager isn’t tied to replicating an index.
Management Style:
The management style of Index Funds remains strictly passive. They track a benchmark by holding its exact stocks in the same proportions, requiring minimal manager input. The process involves mechanically replicating the index to match weights with minimal trades.
The rules are based on algorithms, which ensure a broad diversification and low turnover. This types of funds are ideal for SIPs as they avoid chasing what’s “hot.”
Actively managed funds on the other hand use quantitative models, sector bets or value and growth tilts to actively research, select and trade stocks or bonds to beat the benchmark. Unlike passive funds, these funds require a high manager input and majorly rely on their performance.
Cost and Fees:
Index funds carry a low-expense ratio of about 0.1 to 0.3% thanks to no active trading or star managers. This helps maximize net returns for SIPs. Whereas, active funds charge higher for management, research, and marketing, up to 1-2% this can lead to erosion of long-term compounding.
To understand this with an example, let’s assume you start a monthly SIP of Rs.15,000. Within 30 years with a low cost fund, your SIP grows to approximately 5.3 crores. On the other hand, with an actively managed fund, the same SIP will grow to 3.4 crores. That’s a total of 1.9 crore difference made just by costs and charges!
So what should you choose?
Your choice of funds depends entirely on your goals. If you aim to build wealth with minimal effort, low stress, and a long-term mindset, index funds are your go-to fit for SIP investing. Their passive approach means you don’t have to constantly track fund performance or worry about frequent portfolio changes. Instead, you stay invested in the broader market and allow compounding to work steadily over time.
Index funds can be especially helpful for investors who prefer a disciplined, low maintenance strategy.
With that said, actively managed funds can also have a place in certain portfolios. They may be suitable for investors who understand the associated risks, and are comfortable with market fluctuations, along with a strong conviction in a particular fund manager or investment strategy.
In conclusion, the right choice depends on your goals, risk tolerance, and how involved you want to be in managing your investments. It is best to consult a registered investment adviser before making your investment choices as they guide you through your goals and make most suitable suggestions based on your time horizon and risk tolerance.
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