Learning how to invest can be fun, but it can also be a little intimidating when you start reading about the various forms of investments, especially if the first book you pick up isn’t designed for a first-time investor. This article covers the differences and similarities between mutual funds and index funds, two of the more popular forms of investing you have probably heard of but you may not completely understand.
Table of Contents
- Comparing Index Funds and Mutual Funds
- Mutual Funds – Anything Goes
- Index Funds – Mirror the Stock Market
- The Difference Between Mutual Funds and Index Funds
- Pros & Cons of Investing in Mutual Funds
- Pros & Cons of Investing in Index Funds
- Which is Better – Mutual or Index Funds?
Comparing Index Funds and Mutual Funds
Both mutual and index funds are collective investments, an investment where investors pool together their money to make a collective investment they wouldn’t be able to make on their own. Collective investments often have preset criteria they try to achieve, such as investing in a certain market or type of investment. This is ideal for beginner investors who may not be able to fund a well-diversified investment portfolio with a small budget. Mutual and index funds have several similarities and differences, which are covered below.
Mutual Funds – Anything Goes
Mutual funds are professionally managed investment funds that pool together resources from many different investors to reach the fund’s investment objectives through buying and selling the fund’s investments. Most mutual funds are overseen by trustees or boards of directors, ensuring that the funds are managed properly and in the best interest of the investors. The management company monitors mutual fund portfolios (usually called a portfolio manager). The goal of a mutual fund is to beat the market.
Types of investments
Investments in mutual funds are made in securities like stocks and bonds, money markets, other mutual funds, and/or commodities such as precious metals. Many mutual funds are created in a specialty or sector. For example, a specific mutual fund may only contain investments in a certain stock class (such as value stocks, dividend stocks, etc.), or a sector, such as technology, medical, financial services, utilities, commodities, etc.
In some cases, mutual funds are not taxed on income like most other business entities – provided the mutual fund distributes at least 90% of its income to its shareholders and the funds meet additional IRS diversification requirements.
Distributions from mutual funds, including tax-free municipal-bond income, are tax-free to shareholders. In contrast, taxable distributions from mutual funds can either be ordinary income or capital gains, depending on how the fund earned the distributions. Net losses from mutual funds are not passed through to fund investors.
Index Funds – Mirror the Stock Market
Index funds are designed to follow a stock market or other investing index and stick to a set of rules regardless of market conditions. Often, index funds rely completely on computer models without any human decision-making as to which securities are bought or sold.
Because of the lack of human input, index funds are a passively managed investment. The value of the index fund will fluctuate as the value if the index increases and decreases.
The goal of an index fund is to match the market.
Types of investments
Index funds follow the structure of the specific index they match. So if the index is stock-based, the index fund should contain the same stocks proportionately as the stock index.
Index funds can be found for various types of investments, including different stock classes, bonds, commodities, and other investments. Adding or removing stocks to the index usually only happens when new stocks enter or leave the index.
Despite computer models and an attempt to replicate the index used as the model for investing, there is no way to make the investments 100% accurate. The difference between the index performance and the performance of your index fund is called the “tracking error” or “jitter.” Many investment managers offer index funds.
Index funds are a simple investment
You pretty much always know what you will get with an index fund. And because there is a relative lack of human input or a passive quality to index funds, they usually have the advantage of lower fees and taxes. They have lower investment turnover, which can be beneficial at tax time.
The Difference Between Mutual Funds and Index Funds
The primary differences between an index fund and a mutual fund are how they are managed (active vs. passive) and which rules govern the type of investments made. Active and passive management usually results in higher or lower management fees.
Mutual funds have active management and often higher management fees. Index funds are typically passively managed and mimic an index regardless of the market conditions.
Because the criteria for index funds are more or less set in stone, the management fees are substantially lower than most mutual funds.
Pros & Cons of Investing in Mutual Funds
The Pros of Investing in Mutual Funds
Here are 4 major benefits of owning mutual fund shares:
- Convenience – Mutual funds are an easy way for the average investor to buy investments that would be too complex to manage on their own.
- Diversification – Mutual funds can own thousands of individual securities across various asset classes and industry sectors, giving investors broad diversification.
- Professional management – Mutual funds differ from index funds in that they are managed by experienced industry professionals who follow the fund’s stated investment objectives with oversight from the federal government.
- Investment size – You can invest small or large amounts of money in mutual funds, even if you don’t have much financial or investing experience.
The Cons of Investing in Mutual Funds
The advantages are great, but also be aware of these 4 important disadvantages of owning mutual funds:
- Fees – Mutual funds can be expensive to manage. Therefore, they charge investors sales commissions (loads) and annual fees regardless of performance. Instead of buying mutual funds through a broker, you can minimize fees by purchasing shares directly from a fund family.
- Share price calculation – Mutual fund share prices are only calculated and made public once daily. (Stock prices are updated throughout the day, allowing you to take advantage of market movement if you trade frequently.) Since each mutual fund share comprises multiple investments, the price depends on the underlying securities’ net asset value (NAV). Therefore, if you put in a buy or sell order for a mutual fund, the price isn’t set until the official end of the market day.
- Capital gains – Mutual funds must distribute capital gains to their shareholders, regardless of how long they’ve owned the shares. However, suppose you own individual securities (instead of mutual funds). In that case, you can control when you sell the investments, making it easier to control your capital gains taxes (long-term capital gains are taxed at a lower rate than short-term capital gains).
- Phantom gains – Mutual funds that need to raise cash can sell profitable investments and create capital gains for investors, even if the fund has performed poorly. This means you can lose money on an investment in a mutual fund but still owe taxes! As I mentioned above, capital gains in a mutual fund get passed along to its investors.
Pros & Cons of Investing in Index Funds
The Pros of Investing in Mutual Funds
Here are 5 major benefits of owning mutual fund shares:
- Convenience – Index funds are one of the easiest and most convenient investments you can buy.
- Diversification – Index funds track popular investment indices, often tracking hundreds or thousands of stocks across all sectors.
- Passive management – Unlike mutual funds, which actively try to beat the market, index funds are passive, meaning you should track the market (minus a small percentage drag from management costs). Over time, beating the market is incredibly difficult, if not impossible, making index funds a better long-term play for most investors.
- Investment size – You can invest small or large amounts of money in index funds, even if you don’t have much financial or investing experience.
- Low expense ratios – Index funds charge extremely low management fees, leaving more of your money compounding.
- Tax efficiency – Index funds match their respective index, so they only need to make trades to ensure their underlying investments replicate the index. The lower churn and fewer stock trades make index funds more tax efficient in the long run.
The Cons of Investing in Index Funds
The advantages are great, but also be aware of these important disadvantages of owning mutual funds:
- Share price calculation – Like mutual funds, share prices are only calculated and made public once daily. Therefore, if you put in a buy or sell order for a mutual fund, the price isn’t set until the official end of the market day.
- Index funds may underperform some mutual funds – The goal of index funds is to track a market, not beat it. While mutual funds try to outpace the market. While some mutual funds will succeed, it’s impossible to know which will do so in advance.
Which is Better – Mutual or Index Funds?
When deciding which type of fund to invest in, you need to consider your investment goals and the investment goals of the fund. An index fund may be a better option if you try minimizing fees and maintaining a simple investment. If you are looking for an actively managed product and are trying to beat the market, you may want to consider a mutual fund.
Everyone wants to beat the market if they can, but it doesn’t always work out that way. When researching mutual funds, remember the types of investments offered by the fund, the fund manager’s history, the fund track record, management fees, and anything else that may affect your decision to invest. Also, keep in mind that past results do not guarantee future returns.
Where to purchase mutual funds and index funds.
You can purchase mutual and index funds through almost any brokerage firm or at some larger banks. This list of the best online discount brokerage firms is a good start.
Similar investments: See exchange-traded funds (ETFs) for a type of investment similar to a mutual fund but different in how it is traded.