Index Funds vs Mutual Funds: What’s the Difference?
Index funds and mutual funds are two of the most commonly held and traded securities. Both funds seek to provide a low-cost and simple way to diversify a portfolio without the investor needing to pick and choose specific stocks or bonds.
Because these two terms have quite a bit of overlap, it’s important to understand what the key differences are when deciding how to invest.
When you hear the term “mutual fund,” this refers to the structure that the fund has.
On the other hand, the term “index fund” involves the investment strategy that the fund has. A high number of index funds will be structured as mutual funds. It’s also possible for mutual funds to be index funds.
Here’s a detailed guide on how index funds compare to mutual funds.
What Are Index Funds?
An index fund is a fund that invests in assets within a specific market index. The goal of an index fund is to attempt to mimic how a market index is performing.
An index refers to a preset group of stocks, bonds, or other assets – most well-known is likely the S&P 500. Because of how an index fund is structured, these funds tend to be passively managed.
It’s possible to structure an index fund in a variety of ways. For one, you could structure the index fund to be a mutual fund. It could also be made to be an exchange-traded fund. Exchange-traded funds are unique in that their value varies depending on the fund’s performance in a specific trading session.
On the other hand, anyone who invests in a mutual fund will be purchasing a stake in the specific company that the mutual fund is based on. ETF investors will be selling or buying ETF shares with other investors.
If you decide to invest in an index fund, you could benefit from a higher amount of diversification, less fees, and consistent returns over an extended period of time.
What Are Mutual Funds?
A mutual fund is a type of investment vehicle, meaning it is a way to structure an investment fund, as opposed to a strategy that fund investors are using.
Mutual funds pool assets from multiple investors to purchase and sell various securities. The investor only has to trade the mutual fund, and not the individual securities within the fund, in order to diversify their portfolio.
Mutual funds invest in a variety of securities, some even invest in the entire market – these would be index funds. Fund managers dictate the strategy they are going to implement in the fund, maybe it’s a technology-sector fund, or maybe it’s a dividend-paying fund.
These funds are actively managed by an investment professional, meaning they buy and sell securities on a regular basis with the goal of outperforming the overall market.
The share price of mutual funds changes based on the net asset value (NAV) of all assets held. NAV is calculated by dividing the total value of the fund’s assets by the total number of shares outstanding.
This means that changes in NAV do not reflect changes in the shares of a single company, but instead the net change of all companies in which the fund invests. This price is calculated at market close, meaning the price will not vary during trading sessions.
Before investing in a mutual fund, keep in mind that these funds tend to charge annual fees, which you should take into account when calculating your returns.
The main reason to invest in a mutual fund is that you could obtain high returns as well as portfolio diversification. There are also a considerable amount of options available to you.
How These Funds Differ From One Another
The key difference between index funds and mutual funds is that index funds refer to the securities that are within the fund — the strategy — while mutual funds refer to the type of investment vehicle itself — the structure. It is possible to have a mutual fund that tracks a market index, making that mutual fund an index fund.
An index fund can be a mutual fund or an ETF, and a mutual fund can have a variety of strategies, including a passively managed index fund.
In other words, an index fund can be a mutual fund, and a mutual fund can track an index, but there are index funds that are not mutual funds, and there are many mutual funds that are not index funds.
The main difference between index funds and mutual funds involves how they are managed. Mutual funds are actively managed since investment decisions need to be made on a daily basis.
When it comes to index mutual funds, it’s common for investment decisions to be automated since the purpose of a mutual fund is to track with an index.
When an index fund is passively managed, the performance of this fund is based solely on how the stocks within the index move in regard to price. As for mutual funds that need to be actively managed, a management team or fund manager typically makes investment decisions while the mutual fund is ongoing.
Mutual fund managers will oftentimes search for other investments to add to the fund from numerous indexes. Any stock can be invested in as long as the selection matches the purpose of the fund itself.
The manager responsible for the mutual fund will decide which stocks to invest in and the number of shares that will be purchased. It’s also possible for the manager to take investments out of the fund. Keep in mind that actively managing funds come with a certain amount of risk since the purpose of these funds is to beat market performance.
Since mutual funds are actively managed, there are more people involved in the running of funds. Investment managers are paid for this labor, while the management company also must pay out traditional costs of running a business — office space, employee benefits, etc.
All of these costs are added together before being divided into a fee that each investor within the mutual fund pays. This fee is referred to as the mutual fund’s expense ratio.
In the event that you invest in mutual funds, the fees that you’ll need to pay will come directly from the fund, which means that there’s less money available to compound over time. Investors pay more to own shares of a mutual fund in the hopes that it will outperform passively managed index funds, but the higher fees cut directly into the returns received from the fund.
Index funds of course cost money to run as well, but it is significantly lower when the fees are not paying a full-time salary for an investment manager. For managed index funds, the expense ratio can be around 0.5-1.0%. In comparison, the ratio for a passive index fund is typically around 0.2%.
Investment Goals of Index Funds vs Mutual Funds
Another clear difference between these two types of investments involves the core goal that the investment has. The sole objective of an index fund is to mirror the performance of an underlying benchmark index: the S&P 500, Dow Jones Industrial Average, or the Russell 2000.
Mutual funds, on the other hand, attempt to outperform the broader market through active management. Investment experts, the fund managers, strategically choose investments they believe will boost overall performance.
Advantages and Disadvantages of Index Funds
While an index fund can be a smart investment for many individuals, it may not be ideal for every portfolio.
Advantages of an Index Fund
As with many types of investment funds, index funds have a considerable amount of diversification as a result of investing in a wide variety of different assets. If your investment portfolio is properly diversified, you may not take on as much risk.
Since index funds are based entirely on the movements of an index as opposed to a situation in which the fund needs to be actively managed, these funds are much cheaper to invest in. The process of selecting investments is automated, which means the expense ratio for an index fund is lower.
Lower tax burden
The index funds that are deemed to be mutual funds can have less tax liabilities as a result of lower turnover. Reduced taxes are possible for index ETFs.
Potential to outperform active investments
Even though index funds are designed to provide investors with low yet consistent returns, there are times when an index fund will outperform active investments like mutual funds. Index funds that are tied to the S&P 500 index tend to perform very well and will typically outperform the majority of investors over time.
Disadvantages of an Index Fund
Delivers Average Returns
Index funds provide investors with specific returns that are proportional to the amount each individual has invested. When investing in this type of fund, your money supports every investment, which means that you can’t avoid poorly performing assets. Even if the index fund performs well one year, it could perform poorly the next.
Performance Relies on the Index
If the index fund you invest in tracks a bad index, your returns can be lower.
Advantages and Disadvantages of Mutual Funds
Mutual funds have some clear pros and cons that you should be aware of.
Advantages of a Mutual Fund
Whether the mutual fund you invest in is centered around the entire market or a specific sector, mutual funds provide investors with ample diversification, which includes a lower amount of risk as well as less volatility.
Potential to Outperform the Market
There are times when a mutual fund will outperform the market, which can result from a mutual fund manager selecting the right stocks to invest in.
Relatively Low Cost
Even though the costs associated with an index fund are typically affordable, it’s possible to keep costs down with a mutual fund by investing in an index mutual fund.
Disadvantages of a Mutual Fund
Expense ratio may be high
Mutual funds that are actively managed tend to come with high expense ratios when compared to index funds and ETFs.
Capital gains distributions
Once you reach the end of the year, you may be tasked with paying taxes on capital gains from a mutual fund even if you have yet to sell your share of the fund.
Potential to underperform
While the goal of a mutual fund is to outperform the market, it’s possible for these funds to perform poorly if they aren’t managed well.
Commission and Fee Requirements
Some mutual funds require investors to pay a commission fee that amounts to upwards of 2-3% of your entire investment, which can be costly if the fund doesn’t perform well. Choosing the right mutual fund will help you avoid paying commissions.
Why Invest in Index Funds and Mutual Funds?
Both mutual funds and index funds can provide a relatively low-cost vehicle for adding diversification to your portfolio. If you choose to invest in mutual funds, be cautious of active trading in and out of the fund, this likely will just accumulate fees. There also is no reason to trade in and out actively, that is what the active manager you’re paying for is there for.
Actively trading an index fund also is not the best idea. By nature, index funds are meant to be passively held — investors choose index funds to get the long-term returns of the broader market.
The Bottom Line
Both mutual funds and index funds can provide a relatively low-cost vehicle for adding diversification to your portfolio.
While index funds and mutual funds both involve assets being pooled together to invest in different stocks, there are still differences between them. These two funds differ in investment goals, strategies, and cost bases.
This material is provided for informational purposes only and should not be relied on as investment advice.