What is the difference between equity and index fund?

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Equity and index funds are both different categories of mutual funds. The only similarity they have is that they pool money from investors and then use that pooled corpus to invest in their designated underlying corpus, depending on their investment objectives. It is the underlying assets that are different between different categories of funds. All the differences between these two funds stem from this criteria of underlying assets.

Here are the main distinctions between the two funds.

Equity vs Index Fund:

Underlying assets: 

Equity Funds: Equity funds, as the name suggests, invest most of their funds in equities. According to rules and regulations mandated by the Securities and Exchange Board of India (Sebi) which is our markets regulator, equity funds need to invest at least 65% of their assets in stocks of different companies. Rest can be in cash or debt although rarely do equity funds keep any money in debt securities. There could be rare examples of equity funds keeping a % or two in debt securities. 

There are large cap funds which invest in large cap stocks, mid-cap funds in midcap stocks, small-cap funds in small cap stocks. There are also some multi cap funds, like Parag Parikh Long Term Equity Fund, which has to invest 65% of its funds in equity and the equity allocation can be across market cap categories. 

Index funds: Index funds, again as the name suggests, invests its assets in a stock index. The stocks comprising an index fund will be in exact proportion and weightage as they are in the index. Which means, all an index fund has to do is to imitate the movements of a stock market index. 

Example: Let’s take the example of Nippon India Index Fund. This index fund has both plans: a Nippon India Index Fund-Nifty Plan that imitates Nifty 50 and a Nippon India Index Fund-Sensex Plan that follows Sensex.

The returns of the index fund and the respective index will almost be the same. If you want to invest in index funds, you should know that there will be a difference of a few percentage points always between how much an index actually returns and how much your fund returns because the fund has a few charges like expense ratio and stamp duty (which is charge that all funds have for sure), theN there are amc charges, exit and entry loads which may or may not be levied etc. Your returns may be partially compromised due to the charges.

Index vs equity fund: Management Style

Management style is the next important difference between equity and index fund.

Equity funds: Equity funds are mostly actively managed funds. because the fund manager has an active involvement and say in which stocks can go in the fund and when, how much of the funds will go into buying how many stocks of which firm, when will these stocks be sold and how much, basically everything. Any decision regarding the fund;s composition is a fund manager’s responsibility. Hence, equity funds are actively managed funds. 

Index funds: Index funds simply copy the movements of an index. The fund manager has to diligently copy the movements of the index the fund is attached to. He or she does not have any active say in the fund’s management. Hence, index funds are passively managed funds. 

Equity vs index fund: Expense ratio

Equity funds: Equity funds expense ratio generally ranges up to 2.25% however the charge may be higher in a few cities for select funds. 

Index funds: Since index funds are not actively managed funds, the expense ratio is also lower. The expense ratio for index funds is usually capped at 1%. They are much cheaper than equity funds because the level of services required from the AMC’s end is much lower.

Who should invest where?

Equity fund: There is a clear distinction between the investor profile for equity and index funds. Equity funds are riskier. Equity as an asset class is risky. So, if you look at individual asset classes, equities are riskier than bonds and if you look at mutual funds, equity funds are riskier than debt funds. However risk and returns go hand in hand. Higher the risk, higher the returns. 

To even out the risk, you need to do proper research into which equity fund is good and suits you and stay invested for longer periods without being deterred by short term disruptions.

Index funds: The motive of equity fund managers is to beat the benchmark whereas all index funds have to do is copy the benchmark. The returns might be moderate over a longer period of time but the risk is lower. So you can invest in index funds if your risk profile is lower and you are okay with imitating benchmark returns only.

So to sum it up, if you think you can take higher risks, go for equity funds. Risk averse investors can go for index funds. However whichever category you go for, do not completely ignore the other categories. Diversify your investments.