Index Funds vs. Mutual Funds: 3 Differences that Matter

Article Summary:

Index funds and mutual funds are two types of pooled investment vehicles that hold a basket of stocks and securities. Index funds are a type of mutual fund. This article compares index funds and actively managed mutual funds, which is what most people mean when they compare the two. Actively managed funds and index funds do differ in several aspects, such as management structure and fees. Although the managers of mutual funds strive to make better returns than those of index funds that simply track a market, they often don’t.

The three main differences between actively managed funds and index funds are how they are managed, their goals, and their costs. Index funds are passively managed mutual funds that track an index of stocks. Actively-managed mutual funds, on the other hand, have managers that buy and sell stocks and securities within the fund. Therefore the cost of mutual funds will usually be higher than that of index funds. Depending on your investment goals, you might decide to invest in one, the other, or both.

Index funds 101

Index funds track, or mirror, a market index. For instance, there are index funds that track stock markets like the Nikkei, S&P 500, and Nasdaq. There are also index funds that track subsets of the market, such as high-growth tech stocks or gold. Most people know index funds through exchange-traded funds, or ETFs, which can be bought and sold on the stock market. However, you can also invest in index funds directly rather than through an ETF structure. The major difference is that you can buy and sell ETFs throughout the day. But you can only trade index funds at a set price point at the end of trading hours.

How index funds are managed

Index funds are passively managed, which means fund managers are not selecting assets or timing when they buy or sell. Instead, the portfolio automatically tracks the assets in an index. For instance, Vanguard’s VOO ETF tracks the S&P 500, which comprises all of the stocks that make up the S&P 500. Vanguard’s VUG ETF tracks stocks that are in the S&P 500 but a certain subset related to high-growth metrics. Whichever index the fund follows, the point of the fund is to merely track this index of stocks. If the index goes up, so be it, and if it goes down, so be it. There is no fighting the index; the movement of the index is all-powerful in the index fund.

Mutual funds 101

Mutual funds are similar to index funds in that they are pooled investments of stocks and securities. In fact, some mutual funds are index funds. Actively-managed. mutual funds have traditionally been a mainstay in retirement portfolios. Before the introduction of ETFs, there wasn’t a mainstream way to invest in a pool of securities. Now, people’s retirement portfolios will often consist of at least some mutual funds. Mutual funds in the United States are currently worth close to $27 trillion in assets.

How mutual funds are managed

Actively managed mutual funds are run by professional investment managers who pick assets and securities to buy and sell. The idea of active management is that the managers will be good enough at picking stocks to beat the market. Remember, an index fund tracks the market, whereas a mutual fund wants to beat the market. For example, a fund manager will invest more aggressively when the market is going up. Then they will sell some of the stocks and securities when they feel the market is peaking. They will then switch into more conservative, less volatile stocks or securities in the event of a possible market downturn.

This management style of actively buying and selling based on the manager’s trading philosophy is what sets mutual funds, hedge funds, and others apart from index funds.

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The cost of management

One of the fundamental differences that show up on the balance sheet when comparing index funds vs. actively managed mutual funds is the cost of management.

Index funds

You can think of this like paying an employee. If you have an employee that sits around not doing much work, then you probably won’t pay him much money. Likewise, the employee knows he is sitting around doing nothing and thus doesn’t charge you that much. This works the same way with index funds. The passive management style of index funds means they require very little work and thus have low fees.

Mutual funds

With mutual funds, the cost will be higher as the funds are actively managed. Think of an employee who is doing a lot for the business. He is researching, building Excel models, putting them in PowerPoint, and doing a whole host of other tasks. This employee works hard, and you will have to pay him accordingly. As the managers of mutual funds do a lot more work, they will demand more compensation.

Tax efficiency of ETFs vs. mutual funds

In general, an ETF can also be slightly more tax efficient. When a mutual fund incurs a net gain for a year, then the net gains must be distributed to shareholders. Then they are reported to the IRS, if held in an account that is “taxable.” However, if an ETF manager wants to sell existing holdings for a gain, they can use a unique structure that ETFs provide called “creation units.”

Creation units are considered to be a like-kind exchange and, thus, a taxable event. So in some cases, depending on the ETF, they can work in a more tax-efficient manner, as they make very small amounts of capital gains or no gains at all.

Do mutual funds beat the market?

If you pay someone a significantly higher fee, and their only objective is to help you beat the market, then you must surely beat the market, right? The answer to this question, unfortunately, is no. And in fact, it’s a problem that’s become worse over the years. You can see this on the graph below, courtesy of Dow Jones.

As you can see via the graph, in 2009, only 40.7% of domestic equity funds underperformed the market. In 2021, however, over 80% of domestic equity funds underperformed the market. The majority of these domestic equity funds are mutual funds, and thus, they do not have a great track record of beating the market in general.

What is an investment fund?

An investment fund is a pool of money that investors put into a specific asset or security with the hope of generating a substantial return. There are many types of funds available for investment. As well as mutual funds, you have private equity funds, whose investors’ goal is often to buy companies and spin them off for a profit, and hedge funds, which typically use leveraging or trading of non-traditional assets, to earn above-average investment returns.

Some investment funds deal with alternative assets, such as cryptocurrency or palm oil plantations in Southeast Asia. Mutual funds are probably the most popular type of investment fund, but mutual funds are not a monolith. There are several types of mutual funds, and it’s important to understand the differences.

FAQ

Are mutual funds or index funds safer?

As index funds merely track a market index, they can’t be considered safer or riskier than the general market. However, because an actively managed mutual fund consists of selected stocks, an investor can opt for a mutual fund that is ultra-conservative. For instance, rather than tracking the S&P 500, the manager would select ultra-conservative stocks that are in the S&P 500. So a mutual fund can be safer than an index fund but needs to be specifically designed to do so. In a general sense, one is not safer than the other.

What are 3 key differences between index funds and mutual funds?

Three key differences between index funds and mutual funds include what they track, how they are managed, and their cost. Index funds track a specific market index, and thus are passively managed with a low cost. Most mutual funds have an active manager picking individual securities, and that costs more.

Is it good to invest in index funds?

It really depends on the investor. However, if you want exposure to the market with a low cost, then index funds can be a good investment.

Which index fund is best?

There is no index fund considered the best. However, some of the most popular are the Vanguard S&P 500 ETF and the Fidelity ZERO large-cap index.

How long should you hold an index fund?

You should hold an index fund for as long as you need to reach your financial goals or time frame. Maybe there is a net asset value you want to reach or a goal, like retirement, you want to reach. There is no specific hold time frame for an index fund, but if invested for retirement, it should be a long hold.

Key takeaways

  • Index funds and mutual funds are two types of pooled investment vehicles that people hope will turn a profit or produce capital gains for the investors.
  • Index funds are a type of mutual fund that differ in where they invest in, how they are managed, and their cost. There can be different tax implications as well.
  • Index funds are passively managed, meaning they go up and down, tracking an index. Mutual funds are actively managed, meaning managers actively buy and sell stocks and securities hoping to beat the market.
  • Although the goal of an actively managed mutual fund is to beat a market or market index, they seldom do.
View Article Sources
  1. Index funds – Investor.gov
  2. S&P Global – SPIVA US Scorecard
  3. How to Invest in Index Funds – SuperMoney
  4. Investment Guide – SuperMoney
  5. Best Low Cost Index Funds – US News & World Report