Index Fund vs. Mutual Fund: What’s the Difference?
December 2, 2022
Index Fund vs. Mutual Fund: What’s the Difference?
December 2, 2022
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Are you overwhelmed by the number of investment vehicles available to you as an investor? A common question some investors have is: Should I invest in an index fund or a mutual fund? According to Investopedia, “Mutual funds didn’t really capture the attention of American investors until the 1980s and 1990s, when investors in them hit record highs and realized incredible returns. They are now mainstream investments and form the core of individual retirement accounts.”
Although mutual funds are still popular with investors, index funds, which were developed in the 1990s, have become popular due to their predictable returns (over the long haul) and their less expensive cost basis compared to mutual funds (per Investopedia). The main differences between an index fund and a mutual fund are how they’re managed, their investment objective, and their cost basis.
What Are Index Funds and Mutual Funds?
An index fund usually invests in a market index, such as the S&P 500, the Dow Jones Industrial Average, the Nasdaq composite, or other market indices. An index fund is designed to mirror the annual return of an index that the fund is tracking. Unlike a mutual fund, it’s considered a passive way of investing with more predictable performance.
Mutual funds are considered active investments; they invest in stocks, bonds, and other securities, and a fund manager is actively choosing and changing fund holdings. For this reason, mutual funds typically have higher management fees than index funds. They are designed to try to beat the returns of a related benchmark index, thus making them a more volatile, less predictable investment.
How Are Index and Mutual Funds Managed?
Because an index fund is automated to select investments that mirror a benchmark index, there is little to no management required. Once you select an index fund you want to invest in, all you have to do is buy shares of the index fund. There is usually no other management needed by the investor. However, the index fund manager has to re-balance the index fund periodically. For example, if one of the companies in the index that the fund is tracking is removed, the index fund manager must rebalance it to reflect the current holdings in the index market.
On the other hand, most mutual funds are actively managed by an investment manager, who chooses investments in asset classes such as stocks, exchange-traded funds, and bonds. These allocations can change daily—even hourly. As a mutual fund investor, your return is based on the investment manager’s performance. We all know it isn’t easy to time the market or repeatedly pick winning stocks, but this is what an investment manager is tasked with. Unlike an index fund manager, a mutual fund manager may be trading in and out of securities. The mutual fund manager must decide how many shares to buy of each security and how long to stay in a trade. Actively managing a position can invite more risk as it’s difficult to know over a short period of time which way the price is going to swing.
Investment Objectives of Index and Mutual Funds
An index fund is simply trying to mimic the return of whatever market index it tracks. It’s important to note that not all index funds are created equally. There’s an index for every industry. If an index fund is tracking a struggling sector or industry, your returns can suffer.
A mutual fund’s investment objective is to beat the returns of a popular market index, such as the S&P 500, but the data shows that mutual fund managers have a hard time beating the market, especially during years that the market is performing well. According to S&P Dow Jones Indices’ annual SPIVA report, about 80% of all actively managed U.S. stock mutual funds underperformed their benchmark in 2021. Although mutual fund managers try to beat the market, only a small percentage succeed.
Examples of Index and Mutual Funds
Below are examples of some of the popular index funds:
- Schwab S&P 500 Index Fund – tracks the S&P 500, which consists of the 500 companies that are in the index
- Shelton NASDAQ-100 Index Direct – tracks the performance of the largest, non-financial companies in the Nasdaq-100 Index, primarily comprised of tech companies
- SPDR Dow Jones Industrial Average ETF Trust – tracks the 30 companies in the Dow Jones Industrial Average index
- Vanguard Russell 2000 ETF – tracks the Russell 2000 index, which contains 2,000 of the smallest publicly traded companies in the U.S
- Vanguard Growth ETF – tracks the CRSP U.S. Large-Cap Growth Index, which seeks to represent the performance of the major growth stocks listed in the U.S. stock market
There are many more index funds in the marketplace. It’s important to note that there are also index funds that track specific sectors and asset classes. There’s an index fund for every industry and asset class, including bonds, real estate, and commodities.
Examples of mutual funds:
- American Funds Washington Mutual F1 (WSHFX) – primarily invests in large-cap common stocks and securities
- Thrivent Mid Cap Stock Fund (TMSIX) – primarily invests in mid-cap companies
- Invesco Small Cap Value Fund (VSCAX) – primarily invests in small-cap companies
- JP Morgan Income Fund (JGIAX) – typically invests in government and corporate funds, C.D.s, and money market funds (link to article when published)
- MFS Blended Research International Equity Fund (BRXAX) – mainly invests in large-cap international stocks
Like index funds, there are many more mutual funds that invest in every industry and asset class—choosing a mutual fund will depend on your investment objectives.
In addition to management style, another key differentiator between index funds and mutual funds is their cost basis. Mutual funds typically have two types of fees: annual fund operating expenses and shareholder fees. The fees from the fund operating expenses go towards paying the cost of the investment managers and whatever costs that are associated with running the business. The shareholder fees include sales commissions and fees for buying and selling mutual fund shares. Because mutual funds are often frequently trading, they can also trigger taxable events for shareholders, thus creating additional (sometimes unexpected) costs.
Index funds primarily have only one type of fee: an expense ratio, which is the cost of owning shares of the index fund. For every $10,000 invested, it typically costs $3 to $10 per year to invest in an index fund. There are also some funds that do not charge an expense ratio at all.
According to Bankrate, the average fee for owning an index fund is 0.09%, where the fee for owning a mutual fund is much higher at 0.82%. Over an extended period, these fees can drastically impact your return. Over 30 years, for example, if you started with $1,000 and got a return of 7% per year, you’ll pay $1,800 in fees when owning an index fund, but your costs for owning a mutual fund can be as high as $15,000 (per Bankrate). There’s another less transparent way that fees can affect your returns. According to Nerdwallet, “Because it’s deducted directly from an investor’s annual returns, that leaves less money in the account to compound and grow over time.”
Both index and mutual funds can help you achieve your investment goals, albeit using very different approaches with their own set of advantages and disadvantages. The main difference between the two is their management style and cost basis. An index fund is a passive form of investing where the fund simply tries to mimic the return of whatever market index it’s tracking. A mutual fund is more hands-on, in which an investment manager actively manages the mutual fund and usually tries to beat the return of a market index, such as the S&P 500. A mutual fund that’s actively managed can be riskier because asset class selection and timing the market can be difficult. Whether you choose to invest in an index or mutual fund will depend on your investment needs, so consult a financial professional to ensure your investment portfolio is aligned with your investment objectives and financial goals.
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McWhinney, James. (January 29, 2022). A Brief History of the Mutual Fund. Investopedia. https://www.investopedia.com/articles/mutualfund/05/mfhistory.asp
Royal, James (November 01, 2022). Best index funds in November 2022. Bankrate. https://www.bankrate.com/investing/best-index-funds
S&P Dow Jones Indices. (n.d). SPIVA U.S. Scorecard. https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2021.pdf
Simpson, Stephen D. (January 31, 2022). A Brief History of Exchange-Traded Funds. Investopedia. https://www.investopedia.com/articles/exchangetradedfunds/12/brief-history-exchange-traded-funds.asp#
Yochim, Dayana. (September 7, 2022). Index Funds vs. Mutual Funds: The Differences That Matter. NerdWallet. https://www.nerdwallet.com/article/investing/index-funds-vs-mutual-funds