Potential investors tend to know about Index Fund vs Mutual Fund. The main difference between Index fund and Mutual fund is; Index funds invest in a specific list of securities while active mutual funds invest in a changing list of securities, chosen by an investment manager.
Key Points:
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Index funds seek market-average returns, while active mutual funds try to outperform the market.
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Active mutual funds typically have higher fees than index funds.
- Index fund performance is relatively predictable over time; active mutual fund performance tends to be much less predictable.
What is Index Fund?
An index fund is a fund that invests in assets that are contained within a specific index. An index is a preset collection of stocks, bonds, or other assets.
The most well-known may be the Standard & Poor’s 500 Index, which includes the stocks of about 500 of the largest American companies.
An index fund merely mimics the assets in the index, making it a kind of passive investment, as opposed to trying to beat the index with active management.
What is Mutual Fund?
A mutual fund is one way to structure an investment fund, and historically it’s been one of the most popular, though exchange-traded funds (ETFs) are growing in popularity very quickly.
A mutual fund may include many kinds of assets or investment styles, including being an index fund or an actively managed fund.
Literally, thousands of mutual funds exist, 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 say it another way, investors can buy an index fund that’s either an ETF or mutual fund.
They can also buy a mutual fund that’s a passively managed index fund or an actively managed one.
Index fund vs Mutual fund: Table
|
Basis of Comparison
|
Index fund |
Mutual fund |
|---|---|---|
|
Investment objective |
Match the investment returns of a benchmark stock market index |
Beat the investment returns of a related benchmark index |
|
Invests in |
Stocks, bonds and other securities |
Stocks, bonds and other securities |
|
Management style |
Passive. Investment mix is automated to match the exact holdings of the benchmark index |
Active. Stock pickers (fund managers/analysts) choose fund holdings |
|
Average management fee (expense ratio)* |
0.09% |
0.82% |
|
After-fee return of $1,000 annual investment earning 7% average annual return over 30 years |
$99,000 |
$86,000 |
|
Amount lost in fees over 30 years |
$1,800 |
$15,000 |
*Source: Asset-weighted averages from 2016 data from the Investment Company Institute
Example of an index fund
The Vanguard 500 Index Fund is the first index fund to ever exist. The fund tracks the S&P 500 Index and contains shares of all 500 companies within it.
It has delivered an average annual return of 7.84% since 2000, just under the Index’s average in that timeframe.
Example of a mutual fund
Say you plan on retiring in 2045. If you want to maximize your available cash by that time, you might consider a 2045 target date fund, an actively managed mutual fund with an established end date.
To participate, you’d purchase shares of the fund — along with other investors looking to retire around the same time — and your fund manager would buy and sell assets to help you reach your goal by the target date.
The pros and cons of an index fund
An index fund can offer a number of pros and cons. Here are some of the most important.
Pros of an index fund:
- Low cost – Because they’re based on an index rather than actively managed, index funds tend to be much cheaper to own. The fund company doesn’t pay a pricey research staff to find the best investments but instead mechanically copies the index itself. So index funds usually charge a low expense ratio to investors.
- May outperform active managers – Not all index funds are equal, but one of the best — the S&P 500 Index — outperforms the vast majority of investors in a given year and more over time. Here are some of the best index funds to consider.
- Lower taxes – Index funds that are also mutual funds may create lower tax liabilities for investors because they have less turnover. This is mostly a non-issue for index ETFs.
- Diversification – Because they’re comprised of a variety of assets, index funds can offer the benefits of diversification, reducing your risk as an investor.
Cons of an index fund:
- May track a poor index – Again, not all index funds are created equal, and an index fund may track a crummy index, meaning that investors get those crummy returns, too.
- Delivers an average return – An index fund delivers the weighted average returns of its assets. It must be invested in all the index’s stocks, so it’s unable to avoid the losers. So while it may have very good years, it can’t outperform the best stocks in the index.
The pros and cons of a mutual fund
A mutual fund offers a number of pros and cons. Here are some of the most important.
Pros of a mutual fund:
- Can be low cost – Index mutual funds may be cheaper to own than a comparable index ETF, though many mutual funds are actively managed and therefore likely to be more expensive.
- Diversification – Whether it’s focused on a sector or broadly invested, a mutual fund can offer you the benefits of diversification, including lower volatility and reduced risk.
- May outperform the market – Actively managed mutual funds may outperform the market – sometimes stunningly so – but research shows that active investors rarely beat the market’s return over time. If the mutual fund is an index fund, though, it’s going to largely track the index’s performance.
Cons of a mutual fund:
- May have sales “loads” – A sales load is a fancy word for a commission, and the worst funds may charge 2 or even 3 percent 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, which is more typical in mutual funds, tends to underperform the market average.
- Capital gains distributions – At year-end, mutual funds may have to pay out certain capital gains for tax purposes. That means you could be on the hook for taxes, even if you didn’t sell a share of your fund.
Conclusion:
Both index funds and mutual funds can help you achieve your financial goals, but through very different approaches.
With one, you’ll enjoy passive, hands-off investing that offers steady returns.
With the other, you’ll get an actively managed fund that could, in some cases, beat the market.
