Index funds vs. Mutual Funds: What’s the Difference?
New investors often want to know the difference between index funds and mutual funds. The point is that sometimes index funds are mutual funds and sometimes mutual funds are index funds. It’s like asking the difference between apples and sweet foods. Apples can be sweet and sour, while sweet foods aren’t limited to apples. This is the case with mutual funds and index funds.
Here are the main features, as well as the pros and cons of mutual funds and index funds.
Index funds vs mutual funds
Both index funds and mutual funds offer investors the opportunity to invest in a diverse collection of assets. Here’s how they stack up:
- A index fund is a fund that invests in assets contained in a specific index. An index is a predefined collection of stocks, bonds or other assets. Perhaps the best known is the Standard & Poor’s 500 Index, which includes the stocks of around 500 of the largest US companies. An index fund simply mimics the assets of the index, making it a kind of passive investment, instead of trying to beat the index with active management.
- A mutual fund is one way to structure an investment fund, and historically it is one of the most popular, although exchange-traded funds (ETFs) are growing in popularity very quickly. A mutual fund can include many types of assets or styles of investing, including an index fund or an actively managed fund. There are literally thousands of mutual funds out there, and some of them are index funds.
As you can see sometimes an index fund is a mutual fund and sometimes a mutual fund is an index fund.
To put it another way, investors can buy an index fund that is either an ETF or a mutual fund. They can also buy a mutual fund that is a passively managed index fund or an actively managed fund.
The advantages and disadvantages of an index fund
An index fund can offer a number of advantages and disadvantages. Here are some of the most important.
Benefits of an index fund
- At low price – Because they are index based rather than actively managed, index funds tend to be much cheaper to own. The fund company does not pay expensive research staff to find the best investments, but mechanically copies the index itself. Thus, index funds generally charge investors a low expense ratio.
- Can outperform active managers – Not all index funds are created equal, but one of the best – the S&P 500 Index – outperforms the vast majority of investors in any given year and more over time.
- Less taxes – Index funds that are also mutual funds may create lower tax obligations for investors because they have less turnover. This is usually not a problem for index ETFs.
- Diversification – Because they are made up of a variety of assets, index funds can offer the benefits of diversification, thereby reducing your risk as an investor.
Disadvantages of an index fund
- Can follow a bad clue – Again, not all index funds are created equal, and an index fund can track a lousy index, which means investors get those lousy returns as well.
- Provides an average yield – An index fund delivers the weighted average returns of its assets. It must be invested in all stocks in the index, so it cannot avoid losers. So while he may have very good years, he will rarely have a barburner year.
The pros and cons of a mutual fund
A mutual fund can offer a number of advantages and disadvantages. Here are some of the most important.
Benefits of a mutual fund
- Can be low cost – Index mutual funds may be cheaper to own than a comparable index ETF, although many mutual funds are actively managed and therefore likely more expensive.
- Diversification – Whether it’s sector-based or heavily invested, a mutual fund can offer you the benefits of diversification, including reduced volatility and risk.
- May outperform the market – Actively managed mutual funds can outperform the market – sometimes surprisingly – but research shows that active investors rarely outperform the market over time. If the mutual fund is an index fund, however, it will largely track the performance of the index.
Disadvantages of a mutual fund
- May have sales “charges” – A sales charge is a fancy word for a commission, and the worst funds can charge 2 or even 3% of your investment, hitting your returns before you’ve invested a dime. It’s easy to avoid these fees by carefully selecting a fund.
- May have a high expense ratio – If a mutual fund is actively managed, it likely charges a higher expense ratio than an ETF for all the analysts needed to sift through the market.
- May underperform the market – Active management, more typical of mutual funds, tends to underperform the market average.
- Capital gains distributions – At the end of the year, mutual funds may have to pay certain capital gains for tax purposes. This means that you may have to pay taxes even if you haven’t sold part of your fund. (This is one of the advantages of ETFs over mutual funds.)
Should we invest actively or passively in these funds?
Whether it’s pros or individual investors, active management tends to lead to underperformance. Passive investing is an attractive approach for most investors, especially because it requires less time, attention and analysis and always generates higher returns.
If you’re investing in an actively managed mutual fund, you want to let the manager do their job. If you trade in and out of the fund, you are guessing professional investors that you have actually hired to invest your money. This doesn’t make much sense, and it can result in capital gains taxes, if the fund is held in a taxable account, as well as early redemption charges from your mutual fund.
Actively trading an index fund doesn’t make much sense either. An index fund is inherently a passively managed investment, so you buy the index to get its long-term return. If you trade in and out of the fund, even though it is a low-cost ETF, you can easily reduce your returns. Imagine selling in March 2020 as the market collapses, only to see it soar over the next year.
Again, passive investing beats active investing most of the time and more so over time.
At the end of the line
Index funds and mutual funds are not exclusive categories, although it can be easy to confuse them. So you can end up with index mutual funds, and often these stock exchange funds are some of the cheapest funds on the market, even more so than the very popular index ETFs. No matter how your fund is managed, investors will do better by passively managing their own funds.