The Big Question: Mutual Funds or Index Funds?

In the history of investment, mutual and index funds have always been fierce competitors. Both of them have their own set of pros and cons, no doubts there. But analysts recently predicted a shift towards index funds emphasising on its advantages.

An investor choosing a fund primarily depends on one’s goal, budget, tenure and of course, there is the risk factor. Let’s understand about the funds and deduce the big question.

The Nitty-Gritty of Mutual Funds:

  • The best mutual funds are fabricated by pooling money from investors in the form of various resources.
  • The investment is made in the form of securities like stocks and bonds, money markets, commodities and other mutual funds.
  • Mutual funds investments are actively managed, i.e., several experts suggest the stocks that can beat the market.
  • These funds have high expenses in the form of several fees.

Example: HDFC Capital Builder Value Fund (G)

This is one of the funds that are known to perform consistently among mutual funds. Its 10-year returns are 15.85%. This equity value-oriented fund incurs an expense of 2.28%. The capital gains tax on this fund is 10%.

So, what is the deal with Index funds?

  • Irrespective of market conditions, index funds follow an index in the stock market. Well, it’s obvious, isn’t it?
  • Though it draws investment from various resources, an index fund invests according to the specific index it follows.
  • Index Funds are passively managed since computer models call the shots in these funds.
  • Since there is less manual work involved, the expenses are low.
  • Index fund was first introduced by John Bogle, founder of Vanguard.

Example: Vanguard 500 Index Fund Investor Shares (VFINX)

This is one of the best index funds in the market. While this fund offers exposure to 500 of the largest U.S. companies, it has a low expense ratio of 0.14%.

The 10-year returns as of 06/30/2018 are 10.73%. After taxes are applied, the 10-year returns are 9.61%.

Let’s Mix and Match them

  • Mutual and Index funds are two peas in a pod as they both are collective investments. They are formed by accumulating money as a single fund.
  • If one is averse to risk, index funds are the best match. They are less volatile compared to actively managed mutual funds.
  • As for high financial goals, investing in the best mutual funds can come in handy as they yield higher returns. However, some experts argue that since high fees incur in mutual funds, the value of returns is curtailed.
  • An estimate of the amount lost in the form of fees over 30 years: $1800 for index funds and $15,000 for mutual funds.
  • Also, the average expense ratios for index and mutual funds are 0.09% and 0.82% respectively.
  • S&P Dow Indices data in 2016 were analysed for over 15 years. It was found that 90% of various mutual funds couldn’t achieve a consistency like that of index funds.
  • Compared to Mutual funds, Index funds are tax friendly. Mutual funds investments involve capital gains taxes when a holding is sold.
  • However, a tracking error occurs in index funds when the fund deviates from the benchmark. This can affect the overall performance of the fund.

The recent Re-categorisation

  • Securities and Exchange Board of India (SEBI) is the regulatory body for the securities market in India.
  • In October 2017, the SEBI board called for the recategorization of the mutual funds.
  • The aim of this rule is to bring uniformity among the plethora of mutual funds by rationalizing them accordingly.
  • The board instructed the fund houses in India to organize all the mutual funds based on their type of investment. It allowed only one fund per category.
  • By this, investors can understand and pick the funds easily. Several funds were either renamed or merged together.
  • Also, to be listed under a large-cap scheme, the holding should have at least 35% of its corpus in each segment.
  • Some funds had to undergo fundamental changes to fit into the new shoes. You can easily compare mutual funds using the online calculators specifically designed for the purpose.

Impact on the Funds and the Result

  • However, there isn’t much difference in the large-cap funds. The small and mid-cap mutual funds are experiencing a downside at present.
  • Since there are several restrictions placed on large-cap funds at present, the returns may vary.
  • The outperformance of the mutual funds declined by 1.5% annually.
  • The SEBI also pointed out to the exorbitant expense ratios (TER) of the mutual funds. The TER of many mutual funds has gone down dramatically following the changes.
  • SEBI set a bar on the equity mutual funds to 2.5% and 2.25% for debt funds. The board further asked the fund houses to lay down sub-limits based on asset sizes.
  • The mutual fund industry slashed the TERs in February this year.
  • Experts expected a dynamic shift of interest towards the index funds following the recategorizing rule as investors might panic.
  • Analysts stated that the shift towards index funds is a gradual process and investors needn’t panic that it is going to happen overnight.

Should Investors Opt for Index Funds?

All the re-categorization business and its immediate impact on mutual funds returns have led investors to think about opting index funds. However, index funds are not designed to outperform their indices.

Speaking of this, Suresh Sadagopan, Founder of Ladder7 Financial Advisories stated that since the horizon of an index fund is limited to an index, it is always less of competition to a collection of the best mutual funds since they have good returns when picked correctly.

In developed countries, index funds are dominating the market. Nevertheless, in developing countries like India, investors will benefit from mutual funds provided they choose the right ones.

Mutual funds provide a lot of diversity and flexibility compared to index funds. One might argue that the outperformance of mutual funds might decline soon. But, even a little outperformance builds a better principal for the investor who can benefit from the compounding.

Thanks to SEBI, the lowered TERs can bring good returns to the investors of mutual funds. Who knows, the expenses of mutual funds might come down to match that of index funds and still bring good returns. I’m not day-dreaming; this is an expert’s prediction.