Mutual Funds and Index Funds provide diversification by investing across 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. Hence Index Funds invest in the same stocks that are included in the index. Since Index Funds don’t take active decision in choosing stocks for their portfolio, they are called passively managed funds.
Index Funds tend to generate average market return while actively managed mutual funds aim to generate alpha (return in excess of their benchmark return) by taking active calls on stock selection for their portfolio. The higher expected return comes at the cost of higher risk as compared to Index Funds that simply follow an index and generate return is in sync with their index.
Actively managed funds tend to have higher management fees and hence higher expense ratio as they’ve to pay hefty fees to hire fund managers. These funds also incur significant transaction cost due to active trading while Index Funds have fewer transactions in their portfolio. This also make Index Funds more tax-efficient than Mutual Funds. Actively managed Mutual Funds generate capital gains when they sell securities in the portfolio to book profit. This gain, when passed on to investors, increases their capital gains tax liability.
