Comparison is one of the most helpful things you can do when selecting investments. Comparing multiple options allows you to understand what is available in the market and also make an informed choice. It ensures you fully comprehend what you are putting your money into and not merely taking a shot in the dark. If you have been scouring the market for options, the equity fund vs index fund question is perhaps on your mind. Let's find out more about these choices in this article.
What are equity funds?
Equity funds are a type of mutual fund that primarily invests in equities (also known as stocks) and equity-related instruments. These funds typically follow an investment strategy that may be based on a particular theme, sector, market capitalisation, or style.
The Securities and Exchange Board of India (SEBI) categorises equity funds into the following categories:
- Large cap funds
- Mid cap funds
- Small cap funds
- Multi cap funds
- Flexi cap funds
- Large and mid cap funds
- Equity Linked Savings Scheme (ELSS)
- Sectoral or thematic funds
- Value funds
- Contra funds
- Dividend yield funds
- Focused funds
Each of these funds must meet specific criteria laid down by SEBI in terms of asset allocation. For instance, a large cap fund is mandated to invest at least 80% of its assets in large-cap stocks, while a sectoral or thematic fund must invest at least 80% of its assets in stocks from a specific sector or theme.
What are index funds?
Index funds are a type of mutual fund that invests at least 95% of their assets in the securities of a specific market index. In simple terms, these funds mirror the composition of a chosen index and invest in the same stocks and in the same proportion.
Index funds follow a passive investment strategy where the fund manager tries to mimic the performance of the benchmark index.
Key difference between an index fund and an equity fund
Here are some main distinctions between index and equity funds:
- Investment style
The first major difference lies in the investment style of both schemes. Equity funds typically follow an active approach, where fund managers frequently buy and sell shares to capitalise on opportunities within the market. As a result, the asset allocation in these funds may change over time based on prevailing conditions.
In contrast, index funds follow a passive approach. There is no active buying and selling of stocks. Instead, these funds replicate the index they are following by investing in the same stocks. So, you know in advance exactly where your money is being invested.
- Fees
Equity funds generally have higher fees due to active buying and selling. These charges can directly impact your returns, as they reduce the profits you ultimately take home.
Index funds pursue a passive investment strategy, which allows them to have lower costs. So, your returns are less impacted by fees.
However, it is important to remember that while lower fees may seem attractive, the overall returns from both types of funds can vary based on multiple factors. Fees alone should not be the sole deciding element when choosing between the two.
- Diversification and asset allocation
Equity funds offer diversification based on the specific theme, style, capitalisation, or sector they follow. For example, large-cap funds invest primarily in companies with large market capitalisation, while value funds invest in undervalued stocks based on the value investing strategy. Therefore, it is important to understand the fund’s investment approach to determine its asset allocation and see whether it aligns with your financial goals and risk profile.
Index funds also offer diversification, but this depends on the index they follow. For instance, a fund tracking the Nifty 50 will invest in the top 50 listed companies on the National Stock Exchange of India (NSE). Similarly, a fund tracking the Nifty Midcap 150 Momentum 50 Index will focus on the top 50 momentum-driven midcap companies. So, the diversification and asset allocation you get from an index fund depend entirely on the index it follows, and this is what you should examine before investing.
- Tax
All mutual funds, including equity and index funds, are subject to capital gains tax based on their holding period. However, ELSS, which falls under the equity fund category, offers a unique tax advantage. Investments made in ELSS can be claimed as a tax deduction of up to Rs 1.5 lakh per annum under Section 80C of the Income Tax Act, 1961. Index funds do not qualify for this tax benefit.
Index funds vs equity funds - Choosing the right fund based on your goals
Selecting between index funds and equity funds can be confusing, as both invest in stocks, which are part of the equity market. However, there are distinct differences between them that you must understand fully.
Equity funds offer strategic exposure to stocks by following an investment strategy. On the other hand, index funds provide measured exposure to an entire index, mirroring the same stocks and weightage as the index itself. In terms of performance, equity funds aim to outperform the market by actively adjusting the portfolio. On the other hand, index funds seek to match the performance of the index and may or may not beat the index.
You need to consider your financial goals and existing portfolio to decide which one is right for you. Evaluate which option offers better diversification, aligns with your needs, and checks into your long-term financial plan. This can help you select the most suitable investment choice.
Conclusion
Now that you understand the differences between the two, you are in a better position to settle the equity vs index funds debate. Once you have made your choice, go ahead and start investing. Also, aim to keep a long-term horizon in mind, as this can potentially offer better growth over time.
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MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS. READ ALL SCHEME-RELATED DOCUMENTS CAREFULLY
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MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
