Index Fund vs Mutual Fund – Which is Better?

There has always been a confusion in public about Index fund and mutual fund. Where the mutual fund companies do loads of advertising about it. On the other hand, you’ll never see a single advertisement for index fund in India and still many experts recommend that. Which one is better?

Let’s get straight to the point. Before I start, the details of Index Fund vs Mutual Fund, I’d like to point out few limitations.
1. The Mutual fund and Index fund industry in India is quite new. The first index fund launched in India was in 2000.
2. Despite being the industry so new, many of the mutual funds started 20 years ago have not survived till date. The simple reason is because when the funds do poorly, they’re closed by the fund houses, and then a new fund is started with a new name and new strategy.

The funds that performed poorly are now not include in analysis. (We call it survivor-ship bias because now the comparison is only done between the surviving funds which are few selected high performing funds). This makes the mutual fund look better and the analysis will be biased.
3. Most of the so called top performing mutual funds have been in the market for around 10 years or less. In fact, even if you look at the historic prices of the funds that you’re invested in, you’ll see the past performance only until 2013 or 2010. We have not seen a major crises in the global economy since 2008.

History of Index Fund vs Mutual Fund

Now let’s talk about the history of Mutual funds and index funds in india.

When India gained independence, consumers were not saving much citing reason that the earning is very low. Then came the LIC which had salesmen who started going door to door and aggressively selling LIC policies. They did a great job because people started to save. They were taking about 2-3% as fee and promised a return of about 7-9%.

Although it was not bad at that time, however there was an opportunity for people to make more money. Then came the mutual fund companies that started educating retail investors. Their argument was, why bother with 7-9%, when you can earn more than 10% in long term through mutual funds.

Now if you look at the financial market of USA or any developed country, you’ll realize that these people (more than 50% of population) have been investing in equity and equity linked products from more than 50 years. The reality is very different in India. Only less than 10% invests in equity or mutual funds. Hence the market for mutual funds and index funds is very new here.

There is no doubt that in future people will start investing more in Mutual funds and also in Index funds. But what’s the real difference between these two? Let’s find out.

The Real Difference

Mutual Funds are actively managed funds. This means that a fund manager and his team would do a full time analysis on finding the best stocks. Then this stocks are added to the portfolio and worst performing stocks are removed from time to time.

On the other hand, Index funds are passively managed funds. Here, a fund manager will only invest in the index. (Like 30 companies included Sensex or 50 in Nifty). Since the number of companies are limited, the fund manager will be less involved here. As soon as a company is removed from the Index, the fund manager removes that company from the portfolio. Hence less analysis is needed here.

Now the mutual fund might sound like the best idea here. However, the problem starts when we introduce the concept of expense ratio. (Or simply, the fee charged by mutual fund managers and Mutual fund company to do that active analysis).

The maximum fee that can be charged by the Mutual fund companies are capped at 2.5% by AMFI and SEBI. Hence you’ll see most of the direct mutual funds charged anything between 0.5% to 1.5% approx. If you have invested in Mutual fund with the help of a broker or a sales person who assisted you in the transaction, then you’re said to have purchased a regular mutual fund. Here, the expense ratio will be even higher. This is because the extra portion of the expense ratio is regularly paid to the broker who assisted you in the sale.

Regular vs Direct Mutual Fund

Here is the screenshot of a random mutual fund and the difference in expense ratio. You can see the expense ratio in the snip below just next to fund size.

Now there is no difference between the portfolio or asset allocation of these two funds. All else remain the same. The only difference is that the regular plan will end up giving you less return. (As you can notice in the NAV, direct plan has 32.38 and regular has 29.41). If you think 1% of expense ratio will not matter much, Click HERE to read the article on impact of expense ratio, you’ll be surprised. Or you can see the image below if you can analyze it yourself. 

In Index fund, there is no such thing as direct or regular. Usually an Index fund will have an expense ratio of somewhere below 0.50%. Now the question that you must be asking is, if the mutual fund gives much better return as compared to Index fund, then you must be happy to pay the extra fee. Right?

Index Fund vs Direct Mutual Fund

The reality is hardly few mutual funds beats the benchmark (Sensex or Nifty) consistently. Even if they do, they’ll have to also cover the extra expense fee that they’ve charged from you to make it worth.

When we take an average returns out of all the funds, we’ll realize that the index has performed better than the average mutual funds. Here is the data: “According to Refinitiv Lipper data, India’s passive funds have delivered an average return of 9.6%, much higher than active funds’ 5.7%. In 2018, passive funds posted 2.3% gains, while active funds had negative returns.”

If you end up buying those poor performing funds, you’re at loss. Now, you’ll say who wants to invest in those poor performing fund. What if I choose a best performing mutual funds to invest in? That’s good, but not enough!

This is because when a specific fund starts performing, more people start investing in it and thus the fund size keeps on increasing. This means the mutual fund manager will have to look for more better companies to invest for you. The fund manager will have to look for more bargain stock opportunities which are not easy to crack consistently. Hence eventually, a better performing fund usually turns out to be an average. This is why they say, the best performing fund of last decade will be the worst in this decade.

You can read about more limitations of Mutual funds and why I have more invested in stocks here.

The opportunity cost of investing in the wrong fund would be high. If you stay invested in a fund that ended up giving lower than benchmark return, you’ll not be able to get your time and money back.

Why is no one talking about Index Funds?

If the mutual fund companies start telling people that there is no such thing as “best fund” and you don’t need to visit our web sites anymore. I’m sure you know what will happen.

If they tell people to just buy index fund with an SIP and then you won’t have to bother about investing. (Because it is actually that simple), these mutual fund companies will not have their jobs. As I mentioned in my article – 6 principles to achieve financial freedom – (a must read) , that people like to make things complicated. This is because they want to sell you something.

Even the greatest investor of all time – Warren Buffet has advised common retail investors to invest in Index fund as compared to actively managed funds. Warren Buffet challenged the whole of U.S. hedge fund industry to take up the challenge for 10 years from 2007 to 2017. Undoubtedly Warren Buffet won the challenge with a huge margin. His simple explanation was that the expense fee are certain but the extra returns from mutual funds are not.

“Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees. Those following this path are sure to beat the net results [after fees and expenses] delivered by the great majority of investment professionals.”

Warren Buffet, 1996 Letter to Shareholders

FAQs

Question 1 – Index funds provide only average returns

This is true! But it’s a truth designed to fool many. Mutual Fund companies know people want to buy things that are better than average. That’s where they’re winning. As I mentioned earlier, on an average, all the mutual fund gives below average returns. You are taking more risk by investing in actively managed fund to increase your return. More risk doesn’t always mean more return.

Question 2 – You pay high fee because you get more returns

This may be true in a lot of things we buy. But it’s completely wrong in investing. The truth is just the opposite: The more you pay, the less you have for yourself. John Bogle says it this way: “We investors as a group get precisely what we don’t pay for. So if we pay nothing, we get everything.”

Question 3 – The Index fund hold onto those poor performing stock such as Tata Motors or Yes Bank when their stock price was falling until these were de-listed from the Index

True! But many active managers were not only holding Tata Motors or Yes Bank but were also buying more as the price made it an increasingly attractive to them. Mutual Fund companies like to use these examples when they tell investors that index funds do nothing to protect investors from companies that go bad. But the truth is that owning shares in the poor companies as well as the best of the market is one reason index funds are so successful.

Conclusion

“Index funds eliminate the risks of individual stocks, market sectors, and manager selection. Only stock market risk remains.” “If the data do not prove that indexing wins, well, the data are wrong.” “It’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.”

John Bogle

Mutual funds are not bad, they still give you good return as compared to Fixed Deposit or any other investment vehicle. They also create habit of investing. If there were no ads about Mutual funds, you wouldn’t be reading this either. However, when it comes to investing, the best strategy is to always reduce the risk. Not to look for super-normal profit. Because often when we look at more profit, we end up taking more risk unknowingly.

If you have been investing in mutual funds, then stay invested. Don’t take a panic call. Do you own research about the performance and use your own analysis to see if its worth switching over.

As always, mutual funds and index funds investment are subject to market risk. Please do your own research and read the scheme details carefully before investing. The article is based on my opinion.

If you have a different opinion then I’d like to hear from you. You can comment below. If you learned something from this post then you can share it with your friends and sign up for newsletter here.