Index Funds vs. Mutual Funds: What’s the Difference?
It’s easy to get confused about what the terms “mutual fund” and “index fund” refer to. The two terms refer to distinct categories: “mutual fund” refers to a fund’s structure, whereas “index fund” refers to a fund’s investment strategy. Many, but not all, index funds are structured as mutual funds, and many mutual funds are index funds. Generally speaking, though, “index fund” refers to a fund whose investments closely track a market index, while “mutual fund” refers to a broad class of investment funds that follow a range of investing strategies. It’s important to understand the similarities and differences between mutual funds and index funds so you can make an informed investing decision.
What Is a Mutual Fund?
The word “mutual” used in the term “mutual fund” refers to the structure of the fund rather than the investment strategy that the fund’s owners pursue. This kind of fund combines the funds of investors who mutually pool their monies to buy and sell securities. Investing in a mutual fund is not trading shares of specific companies held by the mutual fund; it is trading shares of the mutual fund company itself. Investors buy and sell their stakes in mutual funds at a price set at the end of a trading session; their value does not fluctuate throughout the trading session.
What Is an Index Fund?
The term “index fund” refers to the investment approach of a fund. Specifically, it is a fund that that aims to match the performance of a particular market index, such as the S&P 500 or Russell 2,000. This differs from a more actively managed fund, in which investments are picked by a fund manager in an attempt to beat the market. An index fund does not seek to beat the market – only to match it.
This kind of fund can be structured as a mutual fund, described above, or as an exchange-traded fund (ETF). Unlike a mutual fund, an ETF has a value that fluctuates on a public exchange throughout a trading session. Also, with a mutual fund investors are doing business with the mutual fund company, buying and selling a stake in the company; ETF investors are doing business with other investors, buying or selling shares of the ETF itself.
Key Differences: Management, Goals, Costs
Aside from the distinction described above, there are usually three main differences between index funds and mutual funds. These differences are how decisions are made about a fund’s holdings, the goals of the fund and the cost of investing in each fund. Here’s a breakdown of each differentiator and how it may apply to you.
Active vs. Passive
Many, but not all, mutual funds are actively managed. This requires the fund manager to make daily or even hourly trading decisions.
An index fund – whether structured as a mutual fund or ETF – takes a more passive approach. There is no fund manager actively managing an index fund since the fund is tracking the performance of an index. Index funds aim to buy and hold the securities that coincide with the indexes they track. Therefore, there is no need to buy and sell securities regularly. This is one of the biggest differentiators of index funds vs. mutual funds.
Since there is no fund manager actively managing an index fund, the fund’s performance is solely based on the price movement of the shares within the fund itself. However, with an actively managed mutual fund, the performance is based on the investment decisions the fund managers make. Fund managers are free to choose the securities that best meet the investment objective and character of the fund.
There is a constant debate on which is better, actively or passively managed funds. According to the SP Indices, 78.52% of large-cap funds underperformed the S&P 500 within five years. This highlights that even though the market has experienced high volatility in the last few years, active funds don’t necessarily yield better performing funds.
Another difference is the investment objective each type of fund offers. With index funds, the goal is to simply mirror the performance of an index, while with a mutual fund, the objective is to outperform the market. Essentially, actively managed funds strategically select investments that will yield a higher return than the market.
Investors who seek higher-than-average returns may be more drawn to mutual funds. However, since there is more work required to actively manage a mutual fund, it may cost more. This leads us to our next big difference.
Running an actively managed fund generally costs more than running an index fund. This is because actively managed funds tend to have more expenses such as fund manager’s salaries, bonuses, office space, marketing and other operational expenses. Usually, the shareholders absorb these costs with a fee known as the mutual fund expense ratio.
It’s important to note that the higher the investment fees are, the more they dip into your returns. If you purchase shares of an actively managed fund expecting to yield above average returns, you may be disappointed, especially if the fund underperforms.
However, index funds have fees as well, though the lower cost of running such a security usually results in lower fees. Remember, the lower the management fees, the more the shareholder can receive in returns.
The Bottom Line
Some, but not all, mutual funds are index funds. An index fund tracks a particular market index with the goal of matching its performance. Mutual funds and index funds can be great options for folks who don’t want to take the DIY approach to investing.
But before you invest in either type of fund, it’s important to make sure you understand how that fund works, what the investment objective is and what fees the fund has. Remember that the fees of an index fund or mutual fund can dip into your returns. If you’re unsure which investment is right for you, you may want to speak with a financial advisor who can guide you in selecting the most suitable fund to fit your needs.
Tips for Investing
Consider talking to a financial advisor about mutual and index funds. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
If you don’t have a lot to invest, you might want to consider a robo-advisor. Robo-advisors, which are entirely online, offer lower fees and account minimums than traditional financial advisors.
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