Very important question!
Every mutual fund investor should know this difference. Let me try to explain.
Mutual Fund vs Index Fund
Mutual funds can be categorised into an active mutual fund and passive mutual fund based on the investing style.Actively managed mutual funds are where the mutual fund managers keep buying and selling the stocks from the portfolio.If you ask the logic for active management of the mutual fund, the fund manager will say - “I actively track each stock in the mutual fund to make sure I buy the potential stocks and remove the underperforming stocks. This ensures high returns for the mutual fund as compared to the Index.”
Before we proceed further, please note that the main goal of every active fund manager is to beat the benchmark (index).
An index is a collection of stocks in a specific category.
Actively managed fund charge “additional fee” which is called “expense ratio” to manage the fund. It directly impacts the overall return from the mutual fund but the fund manager try to compensate it with “additional return” compared to the Index.
However, another style of investing is a passive investment in the Index Fund or ETF where the mutual fund manager does not buy or sell stocks on a frequent basis. Passive investing has a very low expense ratio.
The logic behind passive investing is “Efficient market Hypothesis” which says -“It is impossible to generate “Alpha” in an efficient market with active investment. Alpha is an additional return on the mutual fund as compared to its index. An efficient market is where all the required information is available to every investor.” If I put it in simple language, the passive investor says, “Active investment is just a way for mutual fund managers to make money by charging high fee. When everyone has access to all the information for investment, it is useless to keep buying and selling stocks because actively managed fund can’t beat the benchmark (index) in the long run. In fact, the returns from Index would be higher than the active mutual fund. Hence, it does not make sense to pay “high expense” ratio in an active mutual fund.”
But the question is -
Is it really impossible to generate more return with an active investment as compared to an Index fund...
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