Comparing Index Funds and Mutual Funds
Index funds and mutual funds are similar investments which pool together investor's money to purchase a variety of stocks and other investments. This guide explains the similarities, differences, and pros and cons of each.
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Learning how to invest can be fun, but it can also feel intimidating when you start reading about different investment options, 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 may not fully understand.
Comparing Index Funds and Mutual Funds
Both mutual and index funds are collective investments, where investors pool their money to make a collective investment they couldn’t 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
Active management
Mutual funds are professionally managed investment funds that pool resources from many investors to reach the fund’s investment objectives by buying and selling the fund’s investments. Trustees or boards of directors oversee most mutual funds, ensuring they are managed properly and in the best interest of 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 invest only in a certain stock class (such as value stocks, dividend stocks, etc.) or a sector, such as technology, medical, financial services, utilities, commodities, etc.
Taxation
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 meets additional IRS diversification requirements.
Distributions from mutual funds are generally taxable to shareholders as either ordinary income or capital gains, depending on how the fund earned the distributions — the main exception is tax-free municipal-bond income, which is generally exempt from federal tax (and sometimes state tax too). Net losses from mutual funds are not passed through to fund investors.
Index Funds – Mirror the Stock Market
Passive management
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 entirely on computer models, with no human decision-making about which securities to buy or sell.
Because they lack human input, index funds are passively managed investments. The value of the index fund fluctuates as the index rises and falls.
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 hold the same stocks in the same proportions as the index.
Index funds cover various investment types, including different stock classes, bonds, commodities, and other investments. Adding or removing stocks from the index usually happens only when new stocks enter or leave it.
Even with computer models and attempts to replicate the index used as the investment model, 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.
Most use indexes from the S&P 500, Nikkei 225, and FTSE 100. Some rely on educational research indexes, like those by Eugene Fama and Kenneth French, to develop asset pricing models.
Index funds are a simple investment
You pretty much always know what you will get with an index fund. Because index funds have less human input and are more passive, they usually have the advantage of lower fees and taxes. They have lower turnover, which can help at tax time.
The Difference Between Mutual Funds and Index Funds
The main differences between an index fund and a mutual fund are how they are managed (active vs. passive) and which rules govern the investments they make. Active and passive management usually results in higher or lower management fees.
Mutual funds are actively managed and often have higher management fees. Index funds are typically passively managed and mimic an index regardless of the market conditions.
Because index-fund criteria are more or less set in stone, 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 because experienced industry professionals manage them and 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 important disadvantages of owning index funds:
- Fees – Mutual funds can be expensive to manage. As a result, 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 a mutual fund investment but still owe taxes! As I mentioned above, capital gains in a mutual fund pass through to its investors.
Pros & Cons of Investing in Index Funds
The Pros of Investing in Index Funds
Here are 5 major benefits of owning index 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 they 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 very low management fees, leaving more of your money to compound.
- Tax efficiency – Index funds match their respective index, so they only trade to keep their underlying investments aligned with 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. So, if you place 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. 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, consider your investment goals and the fund’s goals. An index fund may be a better option if you want to minimize fees and keep your investment simple. If you want 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, consider the types of investments offered, the fund manager’s history, the fund’s 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), a type of investment similar to a mutual fund but traded differently.
