In short
- An index fund copies a market index. An active fund has managers who choose what to buy and sell.
- Index funds usually cost less each year. Active funds aim to do better than an index after costs, and many don’t manage it.
- Neither is right for everyone. Compare costs, what the fund holds, and how it fits your plan.
First, what a mutual fund is
A mutual fund collects money from many people and invests it together. Each investor owns units, and the value of each unit (the NAV, or net asset value) moves with the value of what the fund holds. You pay for this through a yearly cost called the expense ratio, taken out of the fund quietly.
Index funds
An index is a list of companies chosen by a fixed rule, for example the largest companies on an exchange, weighted by size. An index fund simply buys what is on the list, in the same proportions. Nobody is trying to pick winners.
Because there is less research and trading, costs are usually lower. The fund follows the index closely but not perfectly; the small gap is called tracking error.
Exchange-traded funds (ETFs) often do the same job, but you buy and sell them on an exchange like a share, so you need a demat account (see demat and trading accounts).
Active funds
An active fund has a manager and research team who decide what to buy, what to avoid and when to sell, aiming to do better than a chosen benchmark index. That work costs money, so the expense ratio is usually higher.
Some active funds beat their benchmark after costs in some years. Doing it consistently over long periods is harder, and past winners often don't stay on top (see why chasing last year's winner often disappoints).
Side by side
| Index fund | Active fund | |
|---|---|---|
| How it chooses | Copies an index by a fixed rule | A manager picks and changes holdings |
| Yearly cost | Usually lower | Usually higher |
| What it aims for | To match the index, minus costs | To beat a benchmark, after costs |
| Extra risk | Small gaps from the index | The manager's choices may lag the benchmark |
| Market falls | Falls with the index | Can fall too, sometimes more |
What people compare
This isn't a recommendation. These are the things worth looking at either way:
- The expense ratio, and whether it is a direct or regular plan. Regular plans include a distributor's commission, so they cost more each year.
- What the fund actually holds, and whether it overlaps with what you already own (see what diversification actually means).
- For an active fund, how it has done against its benchmark over long periods, after costs. Past results don't predict future ones.
- For an index fund, how closely it has followed its index.
Whichever you choose, the market itself can fall. Neither type protects you from that.
Try it: two piles, two yearly costs
Two people each put in ₹1,00,000 [hypothetical]. The investments behave the same; only the yearly cost differs. To show costs alone, imagine the investment itself doesn't grow or fall.
Both piles start at ₹1,00,000 [hypothetical]. Move the years slider to watch them drift apart.
Made-up numbers for teaching, not real funds or expected returns. Real investments also rise and fall, and costs come out either way.
Educational content only. Not investment advice. Examples marked [hypothetical] are made up for teaching and do not show real or expected returns.