Index Funds vs Mutual Funds
Index Funds vs Mutual Funds: An Overview
Although these terms are often confused with being similar, they differ in terms of management style, portfolio composition, objectives, and fees.
Mutual funds refer to a fund’s structure, while index funds refer to an investment technique.
An index fund tracks a specific market index, such as the S&P 500. The management of such a fund is passive, as its main aim is to mirror the performance of the index it monitors.
On the other hand, in a mutual fund, the securities are changing and depend on the discretion of a fund manager who actively manages the fund. Its main aim is to outperform the market or a specific index.
What Are Index Funds?
An index fund is a type of mutual fund that is passively managed. Including the equities of the companies that make up the market index, it aims to mimic that index’s performance, not outperform it.
Advantages of Index Funds
The main advantages are listed below:
Index funds are often less expensive to hold than actively managed funds due to their index-based nature. Instead of paying for expensive research staff to identify the best assets, the fund provider automatically replicates the index.
Index funds also offer the advantage of being relatively tax-efficient as they tend to have lower turnover than actively managed funds. Thus, there are fewer capital gains to be taxed.
Disadvantages of Index Funds
Index funds are not without drawbacks. Some of them are discussed below.
Lack of Flexibility
The fund manager cannot choose which asset classes to include or exclude, resulting in a lack of flexibility. It is disadvantageous if the investor cannot prevent a decline in the market index the fund tracks.
Another disadvantage of index funds is that they may not offer as much return as actively managed funds. An investor in an index fund cannot outperform the benchmark of the market it tracks.
Examples of Index Funds
A famous example of an index fund is the S&P 500 Index Fund which tracks the S&P 500 market index.
Another popular example is the Vanguard Total Stock Market Index Fund which tracks the performance of the CRSP U.S. total market index.
Others include the Dow Jones Industrial Average Index Fund and the Nasdaq Composite Index Fund.
Index funds also track specific sectors, such as energy or technology.
What Are Mutual Funds?
Diversification, professional management, and the flexibility to invest in multiple assets in mutual funds result in lower risks for investors.
Advantages of Mutual Funds
Listed below are the primary advantages of mutual funds:
Advanced Portfolio Management
The fund manager of a mutual fund can access a team of professionals working to manage the assets in the fund and ensure it performs well and meets its goals.
It also offers diversification. The fund will be invested in various assets to help reduce risk. Mutual funds can also be invested in multiple markets, which can help lower risk if one company fails.
Convenience and Fair Pricing
Mutual funds can easily be purchased through a broker and are effortless to sell. Mutual fund shares are also priced reasonably. The owners will not have to worry about overpaying for the shares.
The majority of mutual funds establish relatively low minimum and subsequent investment amounts. Shares of a mutual fund can conveniently be redeemed at any time for the current net asset value (NAV) plus applicable redemption costs.
Disadvantages of Mutual Funds
The disadvantages of mutual funds are discussed below:
High Management Fees
Mutual funds can be disadvantageous because they often have high management fees due to active management. The fund manager will take a percentage of the assets in the fund as their fee. It is essential to research the fees before investing in a mutual fund.
Mutual funds were seen to have some fund management abuses. Some fund managers make decisions that are not in the investors’ best interests, such as engaging in insider trading or market timing.
Examples of Mutual Funds
Companies like Vanguard and Fidelity dominate the mutual fund market. These companies have trillions in their total assets.
An example of an established mutual fund is the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX), with a total asset of $1.3 trillion.
The Fidelity 500 Index Fund (FXAIX) has a total asset of $380.7 billion and is another mutual fund example.
With a total asset of $808.8 billion, Vanguard 500 Index Fund Admiral Shares (VFIAX) is another choice for mutual fund investment.
Key Differences Between Index Funds and Mutual Funds
The following is a list of the key differences between index funds and mutual funds:
A fund manager actively manages mutual funds and chooses the assets included in the fund based on their investment goals.
Index funds are passively managed. Automated investment selection matches the identical holdings of the benchmark portfolio.
Mutual funds’ primary investment objective is to generate returns that outperform the market. Index funds, in contrast, aim to mirror the performance of a particular market index through their investments.
The total expense ratio for mutual funds is higher than for index funds because fees are associated with the fund manager’s active management of the assets. A range of 0.5% to 1.5% is the typical expense for mutual funds.
The total expense ratio for index funds is lower than for mutual funds because there are no fees associated with the fund manager’s active management of the assets. The total expense ratio is usually 0.2% for these passively managed funds.
The performance of mutual fund portfolios depends on the fund manager’s skill. The best fund managers can produce returns that outperform the market. The performance of active mutual funds is typically far less predictable.
The performance of index funds is limited to the return of the specific market index that it tracks. An investor can expect a reasonably predictable performance of an index fund over time.
The shareholders in index funds may have a lower tax liability than shareholders in mutual funds.
Mutual funds are liable to capital gains taxes. When a fund manager sells assets that have appreciated in value, the fund realizes a capital gain. This capital gain is distributed to shareholders and is subject to taxation.
Index funds usually generate lower capital gains, making them more tax efficient than mutual funds.
Index Funds vs Mutual Funds: Which Should You Choose?
Your investing goals and objectives will determine whether you should invest in mutual funds or index funds.
Index funds might be suitable if you want to make a hands-off investment that follows the market. Mutual funds might be a good option if you are looking for an actively managed fund with the potential to outperform the market.
Additionally, index funds are considered tax-efficient, so they can be a better option if taxes are a problem for you. They are also a good fit if you value low fees, diversity, simplicity, and dependable long-term performance.
Let us say you want to test your mettle by trying to outperform the market, or you would instead delegate your investment decisions to a fund manager. Mutual funds might be a preferable choice in that situation.
Before investing, you must thoroughly understand each form of fund’s unique characteristics, benefits, and drawbacks.
The Bottom Line
Both index and mutual funds are popular in offering fund diversification.
Index funds are passively managed, which means they aim to track the performance of a specific market index. In a mutual fund, the fund manager selects and chooses which assets to hold in the portfolio.
The key differences between mutual and index funds are their management, fees, performance potential, and taxation.
The investment goals and objectives must be considered when deciding between the index and mutual funds. A financial advisor can help you weigh the advantages and disadvantages of these two to determine which one best suits your needs.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.