How are index funds different from other mutual funds?

A mutual fund is a professionally managed company that collects money from many investors and invests it in securities such as stocks, bonds and short-term debt, equity or bond funds and money market funds.

Mutual funds are a good investment for investors looking to diversify their portfolio. Instead of betting everything on one company or sector, a mutual fund invests in different stocks to try to minimize portfolio risk.

The term is typically used in the US, Canada and India, while similar structures around the world include the SICAV in Europe and the open-ended investment firm in the UK.

How are index funds different from other mutual funds?

Mutual funds and index funds provide diversification by investing in many stocks. While mutual funds have the flexibility to choose stocks in order to generate returns in line with their stated investment objective, index funds track a specific index. Therefore, index funds invest in the same stocks included in the index. Since index funds do not make an active decision when choosing stocks for their portfolio, they are called passively managed funds.

Index funds tend to generate a mid-market return, while actively managed mutual funds aim to generate alpha (return above their benchmark return) by accepting active calls on stock selection for their portfolio. The higher expected return comes at the cost of higher risk than index funds that simply follow an index and generate a return is in sync with their index.

Actively managed funds tend to have higher management fees and therefore a higher expense ratio as they have to pay hefty fees to hire fund managers. These funds also incur significant transaction fees due to active trading, while index funds have fewer transactions in their portfolio. This also makes index funds more tax-efficient than mutual funds. Actively managed mutual funds generate capital gains when they sell securities in the portfolio to account for profits. This gain, if passed on to investors, increases their capital gains tax liability.

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