Index Funds / Exchange Traded Fund vs Actively Managed Equity Funds – Here’s the Difference

Mutual funds can never be separated from the risk associated with investing in them. Yet they are among the popular investment avenues as the returns potentially outweigh the risk involved.

Speaking of Equity mutual funds, there is a variety of them. But by large and large they can be classified actively managed and passively managed. Both these offer diversification.

The actively managed funds involve a hands-on approach to investing, and as you may know, they are a plethora of them. When you invest in actively managed mutual funds, the Fund Manager has more involvement in the decision making. Meaning, that they are more active in buying and selling underlying securities of the mutual fund.

On the other hand, passive investing does not involve the fund manager’s active participation to build the portfolio. He/she simply replicates the benchmark index, whether it is as an ‘Index Fund’ or an ‘Exchange Traded Fund (ETF)’.

Now the question is, what is the difference between Index Funds / Exchange Traded Funds vs Actively Managed Equity Funds, and which one is better. Let’s first understand the basic concept of these two funds.

What is an Actively Managed Equity Fund?

An Equity Fund invests a majority of its underlying assets in equity shares of different companies of different sectors with the fund manager actively managing the portfolio. There are various types of equity funds viz. large-cap fund, mid-cap, large & mid-cap fund, small-cap fund, value fund, focused funds, sector & thematic funds, and so on. Each of these finds its distinct place on the risk-return spectrum. Each of these types of funds, depending on their investment mandate track a respective benchmark index. And the objective of an Equity Fund (which is actively managed) is to outperform its respective benchmark index.

What is an Index Fund / Exchange Traded Fund?

Index Funds / Exchange Traded Funds are passively managed that simply replicate a benchmark index. For example, the objective of the Nifty 50 Index Fund is to invest in the constituents of the Nifty 50 and generate returns that closely correspond with that of the index. Moreover, it also mimics the weightage of the stocks in the index.

Unlike actively managed Equity Funds, the Index Fund / ETF Fund Manager does not play an active role in selecting the stocks and sectors to build the fund’s portfolio. In simple words, the Fund Manager simply copies the index and tries to maintain the portfolio in sync with the index.

Index Funds / ETFs vs Active Equity Funds:

The key difference between Index Funds/ ETFs and Equity Funds is in terms of their portfolio, management style, objectives, costs, investment style, and the kind of returns, they can generate.

1. Portfolio:

Index Fund / ETFs invests in specific stocks and other securities on a particular index that it follows. Whereas, Equity Fund invests in securities that the Fund Manager chooses based on the investment mandate of the scheme.

2. Investment Objective:

The Index Funds / ETFs aim at matching the investment returns of the benchmark stock market index, as it simply mimics the respective index. On the other hand, Equity Funds aim to beat the returns vis-à-vis the respective benchmark index with active portfolio management.

3. Management Style:

Index Funds / ETFs follow no style per se; they are passively managed. The fund Managers simply pick securities of the index in the same weights. Whereas Equity Funds, as regards portfolio management style, could follow a value style, growth, or blend of both. It would clearly depend on the type of Equity Fund and its investment mandate. For example, a value fund is required to follow a value style. Thus, Equity Funds involve Fund Managers’ active participation in choosing securities and sectors to invest in.

4. Expense Ratio:

Since Index Funds/ ETF’s do not need Fund Managers’ active participation, the expense ratio of these funds is comparatively lower than Equity Funds. Actively managed Equity Funds, on the other hand, constantly need Fund Managers’ active participation in doing industry research, making crucial decisions during market ups and downswings, buying, and selling the underlying securities, etc. Hence, the expense ratios of Equity Funds are relatively higher.

5. Performance:

As discussed, Index Funds/ ETFs replicate the popular indices. Therefore, the performance of these funds is closely in line with that of its benchmark index. Although these funds can outperform actively managed funds during market highs, they do not offer flexibility to the Fund Manager in managing market downsides. If the fund is generating negative returns due to unfavourable economic conditions, the active Fund Manager can choose the securities to better manage the downside. However, an Index Fund manager does not have that option. Hence, there is a chance that Index Fund / ETFs returns are poor during market downswings.

To Conclude:

Actively managed Equity Funds allow the fund manager to reduce the risk or time the market in case of favourable or unfavourable market conditions. However, in the case of passively managed funds like Index Funds or ETFs, the fund manager does not have that freedom. Novice investors, who have no experience in mutual fund investment can consider investing in Index Funds or ETFs to start with as it does not require constant monitoring. Investing a small amount in Index Funds or ETFs during a market correction and increasing the investment at every fall can help you average out your investment effectively.

Both the funds have their own sets of benefits that help you, the investors to create wealth in the long term. That is why many experts believe that having a good mix of actively managed Equity Funds and passively managed funds like Index Funds / ETFs are necessary for a good portfolio. However, you should decide the investment style and the weightage based on your investment objectives, risk profile, and investment horizon.

Investors can consider the Quantum Nifty 50 ETF Fund of Fund. This forms a core component of an equity investor’s portfolio using a passive approach. On the other hand, investors can consider allocating to a diversified equity basket using actively managed equity mutual funds such as Quantum Long Term Equity Value Fund, Quantum Equity Fund of Fund and Quantum India ESG Equity Fund. Investors can make use of the Asset Allocator Calculator online to rebalance between funds as per the tried and tested 12:20:80 Asset Allocation Strategy.

Happy Investing!

Name of the Scheme	This product is suitable for investors who are seeking*	Riskometer
Quantum Long Term Equity Value Fund An Open Ended Equity Scheme following a Value Investment Strategy. Primary Benchmark: S&P BSE 500 TRI	• Long term capital appreciation • Invests primarily in equity and equity related securities of companies in S&P BSE 200 index	Investors understand that their principal will be at Very High Risk
Quantum Equity Fund of Funds An Open Ended Fund of Funds scheme Investing in Open Ended Diversified Equity Schemes of Mutual Funds	• Long term capital appreciation • Investments in portfolio of open-ended diversified equity schemes of mutual funds registered with SEBI whose underlying investments are in equity and equity related securities of diversified companies	Investors understand that their principal will be at Very High Risk
Quantum India ESG Equity Fund An Open ended equity scheme investing in companies following Environment, Social and Governance (ESG) theme	• Long term capital appreciation • Invests in shares of companies that meet Quantum's Environment, Social, Governance (ESG) criteria.	Investors understand that their principal will be at Very High Risk
Quantum Nifty 50 ETF Fund of Fund An Open-ended fund of fund investing in units of Quantum Nifty 50 ETF	• Long term capital appreciation • Investments in units of Quantum Nifty 50 ETF – Exchange Traded Fund	Investors understand that their principal will be at Very High Risk

* Investors should consult their financial advisers if in doubt about whether the product is suitable for them.
The Risk Level of the Scheme in the Risk O Meter is based on the portfolio of the scheme as on Aug 31, 2022.

Above article is authored by Quantum.

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