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Mutual funds and index funds are two popular investment vehicle types recognized by their key features of offering convenience, diversification and lower risk compared to individual stock picking.
They can benefit the portfolios of all investors from beginner to advanced.
Both have their advantages and disadvantages and the one that is right for you will depend on your personal investment goals.
We’ll dive deeper into the two below, but here are the basic definitions:
A mutual fund is an investment fund that pools together money from investors to invest in a mix of assets including stocks, bonds and other securities.
An index fund is a type of mutual fund that is designed to match and mimic the performance of an underlying benchmark index such as the S&P 500, NASDAQ, and Russell 2000.
All index funds are mutual funds but not all mutual funds are index funds.
By investing in a mutual fund or index fund, you as the investor, will need less time and less expertise to invest. Picking the correct stocks on your own is time-consuming and likely to fail.
Funds will control the decisions on what to invest in.
The investor has control of what type of fund they want to put their money in and what cost they want to pay in fees.In our deeper dive below, we’ll talk about how you can decide what to invest in and the associated costs
A mutual fund is an investment fund that pools together money from investors to invest in a mix of securities including stocks, bonds and other securities.
The fund will used the pooled money to usually invest in a hundred or more securities at a time.
When you invest money into a mutual fund, you are not individually purchasing the stocks the fund contains. You are purchasing actual shares of the mutual fund itself.
Mutual funds can vary in the types of securities they invest in, management style, risk, and what fees they charge for managing your money.
A mutual fund is considered an actively managed fund. Actively managed means that the fund will have a fund manager or investment team analyzing and making investment decisions on how to invest their investor’s money.
To achieve the funds investment goal, which is usually to beat the market benchmark, the fund will use its skill and expertise to choose stocks. This may require the buying and selling of securities on a monthly, daily, and even hourly basis.
Since mutual funds are actively managed by “qualified” investment professionals, mutual funds have high fees compared to an index fund, but much lower fees compared to a hedge fund.
Mutual fund fees: 0.5-1.5%
Index fund fees: 0.04-0.2%
Hedge fund fees: 2% management fee and 20% performance fee
This fee may or may not be important based on the performance of a mutual fund. If the fund consistently outperforms the market, the fee will be irrelevant because the gains from the fund will outweigh the effects of the higher fee.
It’ll just come down to finding funds that consistently outperform the market. This may be hard to do, as a large percentage of mutual funds have underperformed the market historically.
Types of Mutual Funds
A benefit of mutual funds is the variety that they come in.
At a high level, there are mutual funds for:
- Fixed-income bonds
- Short-term debt money market funds
- Mixed funds which invest in stocks and bonds
Within these 4 categories, you can dive deeper into funds targeting something more specific.
Mutual funds can…
- Focus on company size with small-cap, mid-cap, and large-cap funds
- Focus on investing in a particular industry or sector such as health care, technology, energy, etc
- Focus on securities to provide a growth, value, income or a defensive fund
- Focus on international, global, and emerging market securities
As you can see, an investor has numerous routes they could take when deciding to invest in a mutual fund.
If you want to invest in a fund focused on renewable energy shares, you can do that.
If you want to invest in a fund focused on the emerging market of Brazil, there is a fund for that.
And if you want to invest in a fund comprised of defensive stocks to diversify and protect your portfolio, you can do that too.
An index fund is an investment fund that is designed to match and mimic the performance of an underlying benchmark index such as the S&P 500, NASDAQ, and Russell 2000.
If you bought an index fund tied to the S&P 500, that fund is designed to own all the stocks that make up the S&P 500. The performance of the fund will match the performance of the index. It won’t outperform the index or underperform the index.
Why is this attractive?
The attraction of an index fund comes from the accessibility of owning an index of stocks and the broad diversification benefits the fund offers.
Going on your own to purchase every stock within the S&P 500 is time-consuming and can be costly with the purchase price of the stocks themselves and commissions from the purchasing or selling of stocks.
With an index fund, you can quickly purchase and expose yourself to hundreds or thousands of stocks and avoid the transaction costs of purchasing individual shares.
Mutual funds are considered actively managed and index funds are considered passively managed.
Passive management is a type of “set it and forget it” management style requiring less management from the fund.
The fund is not analyzing and trading stocks every day. The fund simply does what it needs to do to mimic the structure of the underlying index it is tied to and that’s it.
This is appealing to investors that do not want to put much thought into their investments or do not have the financial literacy to make informed decisions on their own. They simply pick a fund to invest in and forget about it until retirement or whenever they plan on withdrawing funds.
Due to less management, passively managed funds typically have much lower fees associated with them.
Index funds typically have expense ratios ranging from 0.03% to 0.5%. Compare that to mutual funds with fees from 0.5% to 1.5%.
Mutual fund fees: 0.5-1.5%
Index fund fees: 0.04-0.2%
Hedge fund fees: 2% management fee and 20% performance fee
Index funds have received high praise by investors. Their simplicity and low fees lead them to beat the market more consistently than actively managed funds.
Many books on investing and personal finance recommend young and first-time investors to allocate funds toward index funds, as opposed to mutual funds and individual stock picking.
In the video below, Warren Buffet talks about how he purchased his first stock in 1942.
He says the best thing you could have done in 1942 was to just buy an index fund and hold it. He said if you invested $10,000 into an index fund that reinvested dividends, it would have become $51 million in 2018
Types of Index Funds
Like mutual funds, index funds also offer a wide variety of options.
There are index funds for financial markets across the world tied to…
- Major US indices such as the S&P 500, Dow Jones Industrial Average and NASDAQ
- US bond markets
- Small-cap, mid-cap, and large-cap securities
- Global and international stock and bond markets
- Real estate
- Industry or sector-specific indices
MUTUAL FUND AND INDEX FUND COMPARISON TABLE
|Mutual Fund||Index Fund|
|Goal||Achieve returns greater than a related benchmark||Mimic and match the returns of an underlying index|
|Strategy||Use of skill and experience of fund manager and team to invest||Trade all securities the underlying index is comprised of|
|Assets fund invests in||Stocks, bonds and other securities||Stocks, bonds and other securities|
|Expense Ratios||0.5% to 1.5%||0.05% to 0.2%|
|Risk||Fund manager and team underperform vs related benchmark||Risks are the same as risks for the underlying index the fund is tied to|
|Tax Efficiency||Higher capital gains due to high turnover of the fund||Typically lower capital gains with low turnover|
WHICH IS BETTER? MUTUAL FUNDS OR INDEX FUNDS?
Both mutual funds and index funds have their advantages and disadvantages. Which one is better will depend on your investment goals and what you are looking for.
The main differences between index funds and mutual funds are in their investment objectives, management style, and costs.
Mutual funds: Aim to beat the returns of a related benchmark
Index funds: Aim to match the performance of an underlying index
Based on what you are looking to accomplish, an index fund or mutual fund can be a better option. If you just want to match the performance of the S&P 500, an index fund will do the trick.
If you want to take on more risk and invest in a fund focused on emerging markets, your best bet would be a mutual fund.
The performance of riskier mutual funds may not be worth the chase for above-market returns.
Performance of Mutual Funds
One of the main attractions of mutual funds is the potential for the fund to outperform the market. The outperformance stems from the skill and expertise of the actively managed style of investment.
This begs the question, “Why would I invest in an index fund if I can invest in a mutual fund for performance that will beat the market?”
Well, mutual funds that can consistently achieve returns above the market are historically hard to find. Performance of mutual funds vary and it is also hard for an investor to choose the correct mutual fund that could achieve consistent returns.
Inconsistent returns and higher fees could make a mutual fund a worse investment choice than an index fund.
Performance of Index Funds
Index funds aren’t riskless investments either. They mimic the performance of indices and those indices can go down in value.
Although index funds can decline in value and have negative years, one thing we know about the US market is that it always goes back up over time.
Buying and holding an index fund over the long-term will surely help you achieve profits if history holds true.
Refer back to the YouTube video above where Warren Buffet mentions a $10,000 investment in an index fund in 1942 would grow to $51 million in 2018!
Mutual Funds: Actively managed by a fund manager and team of professionals that actively choose what the fund will buy and sell
Index funds: Investments for index funds are automated to track an index. The choices of what securities are included in an index fund depend on the underlying index.
Your preferences in management style will also determine whether a mutual fund or index fund is better for you.
With passive management, you don’t have to rely on the performance of a fund’s investment team. You simply rely on the underlying index the index fund is tied tied to.
As we just discussed, the US market trends upward over time and you can bank on that for your returns.
Perhaps market returns aren’t good enough for you. Maybe you know a skilled manager or have a hunch that the technology sector is expected to boom in the coming years.
If this were the case, an actively managed mutual fund could be the better option for you.
You’ll have the opportunity to achieve above-market returns and invest in a specific sector or industry.
A big deal-breaker to most investors when it comes to mutual and index funds is the difference in cost in fees.
Mutual funds: Tend to have higher fees ranging from 1% to 3%.
Index funds: Index fund fees are much lower, ranging from 0.04% to 0.2%.
Fees are higher on mutual funds due to the active management style. You pay for the “performance” of the fund manager.
These percentages might seem minuscule when you read them, but the effects on your returns over the course of your life can be substantial.
In the example below, we see the yearly fee costs calculated for a $100,000 investment in an index fund with a 0.05% expense ratio and a mutual fund with a 1% expense ratio.
For an investment of $100,000 in an index fund, you would pay only $50 in fees.
For an investment of the same amount in a mutual fund, you would pay $1,000 in fees.
The fees paid for a mutual fund are 20 times the amount paid for the index fund.
Imagine both funds have the identical performance for 40 years, which could represent the length of your investment career.
Paying 0.05% versus 1% in fees over the course of 40 years could create a gap in the two of hundreds of thousands or millions of dollars.
Mutual funds and index funds both offer investors of all experience levels a great variety of diversified investments.
Picking individual stocks is time consuming and is likely to fail.
By investing in a mutual fund, you let the fund manager make the investment decisions for you.
Although these are experienced professionals, it isn’t always guaranteed they will beat the market.
By choosing to invest in an index fund, you go in knowing that your investment will mimic the performance of the underlying index the fund is tied to.
The best way to invest in either is to begin investing sooner rather than later. Let compound interest work in your favor.