Equity Fund vs Index Fund
Joy and Bhumi are a newlywed couple. Recently, they have been talking about investing their savings. They both know that investing requires a well thought out and careful approach. Joy thinks that equity funds are better for investing while Bhumi thinks they should invest in Index funds.
To put an end to their debate, they research equity and index funds and the difference between them. Here is what they found:
What is an Equity fund
Equity funds try to make high returns by investing in equity or stocks of companies, across all market capitalisations. They are high-risk mutual funds but that means they also have the potential of giving higher returns. The returns are decided by the performance of the company.
At least 60% of the assets of equity funds are invested in equity shares of companies in suitable proportions. The proportions of asset allocation depending on the investment objective. Depending on market capitalisations the asset can be allocated purely in stocks of large-cap, mid-cap or small-cap companies. The Equity funds are managed actively by fund managers who make buying/selling decisions according to market movements.
What is an index fund
Index funds are made with the intent of replicating the performance of underlying indexes like the Nifty or Sensex. The investment portfolio of these funds has representations of the stocks in these indices. Hence, the performance theoretically is identical to the index which is being tracked.
An index fund diversified investment portfolio across various sectors. Index funds have a low expense ratio. They are passively managed, this incurs low expenses. These funds help an investor in managing or balancing the risk in their investment portfolio.
Things to consider before choosing a fund
Before investing in an equity fund or an index fund, it is important to consider these things:
- Risk tolerance: All investments involve some type of risk. It’s important to understand that with investing you may lose some or all of your money. Higher risk also has the potential of a greater return.If you have a long time horizon for your financial goal, you are likely to get higher returns by investing in high-risk assets like stocks or bonds. For short term financial goals cash Investments are more appropriate because inflation risks are lower.
- Cost of investment: The cost of investment is the charge required for the maintenance of the fund. You need to determine how much charge you are willing to pay for your investments.
- Financial goals: Different people have different financial goals. Your goal may be to create retirement wealth or to pay off debt or to save for your child’s education. Financial goals influence investments to a great extent. Determine what you are investing for and what is the amount needed fulfil that goal and invest accordingly.
- Investment timeframe: When you are clear with your financial goals, you will know by what time you need to achieve that goal. This also helps in determining where you should invest and how much. An investment timeframe also helps you in being disciplined with your investment because a shortage of funds can cause you to not achieve your financial goals.
Differences between Equity Fund and Index fund –
One of the main differences between index funds and mutual funds is the type of risk.
In case of equity funds, the risk depends heavily on the market capitalisation of the holdings. Large-cap funds offer stable returns against low volatility. Medium and small-cap funds offer higher returns with high volatility. In a failing market medium and small-cap investments can cause serious loss and vice versa.
In case of index funds, the risk depends on the underlying index. Index funds are much less likely to be affected by market movements because of its diversified portfolio across various sectors, hence volatility is considerably reduced.
Equity funds aim to outperform the current market benchmarks. This is the goal that makes fund managers mix and match holdings. During market decline, equity funds beat the market performance and offer higher returns. However, most of the time this is not the case.
Index funds have outperformed equity funds more than 80% of the time. The reason behind this is that Index funds try to emulate high performing benchmarks like Nifty 50. They replicate the performance of the underlying index instead of beating them.
To invest in an equity fund extensive research is required. For choosing a fund you have to know the past returns, fund managers historical return and experience, total AUM, etc.
Index funds track the same index and usually have the same returns. It is simple to understand and the decision comes down to expense ratio and tracking error.
From an investor’s perspective the most prominent difference between Equity and index funds lies in the operating cost. Expense ratio is the annual cost of managing the operation of the funds. Expense ratio is expressed as a percentage of assets under management (AUM) of a scheme.
In equity funds, fund managers constantly perform extensive market research to actively manage these funds. After this they choose the securities to mobilise assets that are available. Hence, Equity funds have a higher operating cost.
Index funds have a lower operating cost because they are passively managed and don’t require extensive involvement of the fund manager.
What are the types of equity funds?
Equity funds are divided into various types based on investment objective, investment strategy and asset allocation.
Based on investment objectives they are divided into small-cap funds, mid-cap funds, large-cap funds, large and mid-cap funds and multi-cap funds. Based on investment strategy they are divided into Value strategy, growth strategy, top-down strategy and bottom-up strategy.
Equity funds split the portfolio between 60% equity and the rest in debt or between domestic and international equity. Asset allocation is looked at from a tax-efficiency perspective.
What are the benefits of Index funds?
Index funds have many benefits ,like:
Broad market exposure - Index funds have a portfolio similar to an index which ensures diversification across sectors.
Low fees - Index funds have low operating costs because it mimics underlying benchmark and not much market research is required.
Easier Management - Index funds are easy to manage because fund managers don't need to worry themselves about performance of stocks in the market.The portfolio just needs to be rebalanced periodically.
Automated investment- An automated, regulation based investment method is followed in Index funds. The fund managers have a defined mandate of amount to be invested in index funds of various securities. Investment decisions are not influenced by human bias.
Tax benefits- Index funds have low turnover. Fewer trade results in lesser distribution of capital gains, passed to the unitholder.