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If you’re an investor, you’ve probably heard the terms index fund and mutual fund. The two terms are often confused and sometimes used interchangeably. This is because many, but not all, mutual funds are sometimes index funds, and many index funds are sometimes mutual funds.
An index fund is a type of fund that aims to match or track a specific market index. A mutual fund attempts to outperform the market. Read on to learn more about the difference between index funds and mutual funds.
What Is a Mutual Fund?
A mutual fund is an investment vehicle created when a fund house or an asset management company pools money from investors to invest in a collection of stocks, bonds, and other securities. Professional money managers control the pooled investment by allocating the fund’s assets with an aim to yield capital gains for investors. The performance of mutual funds depends on the underlying securities.
When you buy a share of a mutual fund, you’re purchasing the performance of the fund’s portfolio. Putting your money in mutual fund shares is not the same as buying shares of stock. Unlike stocks, mutual fund shares don’t give you the voting rights of any company. A share of a mutual fund essentially represents holdings in a collection of securities, rather than just one.
What Is an Index Fund?
An index fund is a type of mutual fund that aims to match or track a specific financial market index, such as the S&P 500. This type of fund is a passive investment. Instead of actively picking securities to invest in and timing the market to sell them, the fund manager builds a portfolio whose holdings closely match a particular index. Simply put, an index fund doesn’t try to beat the market but rather matches its performance.
Index funds are often structured as mutual funds or exchange-traded funds (ETFs). ETFs are portfolios of stocks controlled by a professional financial firm. Each share represents a small ownership in the whole portfolio. With index funds, it’s the goal of the financial firm to match its performance with the underlying index rather than outperforming it.
ETFs are, by far, the most popular investment vehicle and are growing quickly. Unlike mutual funds, investors can trade ETFs on stock exchanges throughout the trading day. Investors can also short sale ETFs or buy on a margin.
Index Fund vs Mutual Fund Quick Comparison
A couple of differences exist between index funds and mutual funds. But, the primary distinction is in the investment type: index funds invest in securities (usually stocks and bonds contained within a specific market index), while mutual funds invest in a list of changing securities, often picked by an investment manager.
Here’s a quick comparison of index funds vs. mutual funds:
- The goals: The goal of index funds is to match the performance of an index, while mutual funds seek to beat the market.
- Fees: Index funds typically have lower fees than active mutual funds.
- Performance: The performance of index funds is somewhat predictable over time; the performance of mutual funds is much less so.
- Passive vs Active Strategy: Index funds follow a passive investment strategy, while mutual funds tend to pursue an active management strategy.
- Expense Ratio: Index funds have a lower management expense ratio compared to actively managed mutual funds.
If you’re unsure where to get started, you can find a financial advisor through Paladin Registry who can help choose the ideal fund for your investing needs.
Comparison by Aspect
Comparing index funds and mutual funds can be confusing, even with a basic understanding of what they are and how they work. Exploring the differences in-depth can help you to make an informed investment decision.
Passive vs. Active Management
One major difference between index funds and mutual funds is the investing strategy each fund uses: passive or active.
Whether structured as a mutual fund or ETF, an index fund generally follows a passive investing strategy. There’s no need for fund managers to actively manage an index since the fund is closely tracking the performance of a specific market index. Since no one actively manages the portfolio, the performance of index funds is typically based on price movements of individual securities. Index funds seek to trade securities that match the index they track.
Mutual funds require daily and sometimes hourly investing decisions. That’s why this type of fund tends to follow an active investing strategy. Fund managers make all the investment decisions on behalf of investors, and are free to pick stocks and other securities as long as they meet the fund’s investment objective.
The argument on whether to invest in these funds passively or actively has gone on for some time now. Data has shown that actively managed funds have been underperforming more severely year in year out. According to a report by SPIVA scorecard, 75.27% of the U.S. large-cap funds did worse than the S&P 500 within five years. Generally speaking, passively managed funds perform better than actively managed funds.
Another thing that differentiates index funds and mutual funds are the investment objectives each fund serves.
The primary goal of an index fund is to match the performance of an underlying market index. An index fund tracking the S&P 500, for example, would invest in the 500 large American companies within that index. In essence, portfolios of index funds only change when their underlying indexes change.
On the other hand, the investment goal of an actively managed mutual fund is to outperform the market — as such, to earn higher returns by having a professional fund manager pick investments they believe will perform better.
If you decide to invest in actively managed mutual funds over index funds to beat the market averages, it may cost you more to pay the fund manager’s expertise. This leads us to another significant difference between index funds and mutual funds: cost.
Investing in mutual funds typically costs more than index funds. This is because actively managed funds tend to have many more expenses, including the cost of office space, hiring a fund manager and employees, and the other operational expenses. Typically, the shareholders pay these costs in the form of a fee called the mutual fund expense ratio.
If you invest in actively managed mutual funds hoping they’ll perform better than index funds, you might be disappointed. The extra costs in the fund management get passed on to the investor, resulting in lower investment returns.
While index funds also have fees, they are relatively low compared to the cost of running mutual funds. This is one of the reasons why index funds have become popular. Overall, passively managed funds lead to positive performance trends due to their lower fees and the fact that they do not try to beat the market.
The bottom line is, management expense ratio affects the overall performance of a fund. The lower the management fees, the higher the investment returns are for shareholders.
Which Type of Investor Should Invest in Mutual Funds vs. Index Funds?
Now that you know the difference between index funds and mutual funds, which one is right for you? To recap, index funds seek to closely track a specific market index to match its performance, while mutual funds attempt to outperform the market.
Both index funds and mutual funds are perfect for individuals who don’t want a “do it yourself” investing approach. However, before investing in any fund, it’s vital to understand how the fund works, the investment goal, and the fees. Most importantly, remember investment fees can lower your returns.