Mutual funds and index funds are similar in many ways, but there are some key differences that investors need to understand to effectively implement them into an investment strategy. Those differences might include investing style, associated fees and taxes, and how they work.
The choice between an index fund and an actively managed mutual fund can be a hard one, especially for investors who are unsure of the distinction. The differences between index funds and other mutual funds are actually few — but may be important, depending on the investor.
Key Points
• Index funds aim to mirror the performance of a specific market index, using a passive investment strategy.
• Mutual funds are actively managed by fund managers who select securities to potentially outperform the market.
• The costs associated with mutual funds are generally higher due to active management fees.
• Index funds typically have lower expense ratios, making them a cost-effective option for investors.
• The choice between index and mutual funds depends on individual investment goals and preferences for active versus passive management.
What’s the Difference between Index Funds and Mutual Funds?
Index funds and mutual funds are similar in many ways, but they do differ in some others, such as how they work, associated costs, and investment style.
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How They Work
Index funds are a type of mutual fund, interestingly enough. Index funds are distinguished by their investing approach: Index funds invest in an index, and only change the securities they hold when the index changes, or to realign their holdings to better match the index they invest in.
Rather than rely on a portfolio manager’s instincts and experience, an index fund tracks a particular index. There are benchmark indexes across all of the different asset classes, including stocks, bonds, currencies, and commodities. As an example, the S&P 500® Index tracks the stocks of 500 of the leading companies in the United States.
An index fund aims to mirror the performance of a given benchmark index by investing in the same companies with similar weights. With these funds, it’s not about beating the market, it’s about tracking it, and as such, index funds typically follow a passive investment strategy, known as a buy-and-hold strategy.
A mutual fund is an investment that holds a collection — or portfolio — of securities, such as stocks and bonds. The “mutual” part of the name has to do with the structure of the fund, in that all of its investors mutually combine their funds in this one shared portfolio.
Mutual funds are also called ’40 Act funds, as they were created in 1940 by an act of Congress that was designed to correct some of the investment abuses that led to the Stock Market Crash of 1929. It created a regulatory framework for offering and maintaining mutual funds, including requirements for filings, service charges, financial disclosures, and the fiduciary duties of investment companies.
To get people to invest, the portfolio managers of a given mutual fund offer a unique investment perspective or strategy. That could mean investing in tech stocks, or only investing in the fund manager’s five best ideas, or investing in a few thousand stocks at once, or only in gold-mining stocks, and so on.
Fees and Taxes
There may be different associated costs with index funds and mutual funds as well.
Mutual-fund managers generally charge investors a management fee, which comes from the assets of the fund. Those fees vary widely, but an active manager will generally charge more, as they have to pay the salaries of analysts, researchers, and the stock pickers themselves. Passive managers of index funds, on the other hand, simply have to pay to license the use of an index.
An actively-managed mutual fund may charge an expense ratio (which includes the management fee) of 0.5% to 0.75%, and sometimes as high as 1.5%. But for index funds, that expense ratio is typically much lower — often around 0.2%, and as low as 0.02% for some funds.
Investing Style
The two also differ on a basic level in that index funds are a passive investing vehicle and mutual funds are typically actively managed. That means that investors who want to take a hands-off approach may find index funds a more suitable choice, whereas investors who want a guiding hand in their portfolio may be more attracted to mutual funds.
|
Mutual Funds vs. Index Funds: Key Differences |
|
|---|---|
| Mutual Funds | Index Funds |
| Overseen by a fund manager | Track a market index |
| May have higher associated costs | Typically has lower associated costs |
| Active investing | Passive investing |
Index vs Mutual Fund: Which is Best for You?
There’s no telling whether an index or mutual fund is better for you — it’ll depend on specific factors relevant to your specific situation and goals.
When deciding how to invest, everyone has their own unique approach. If an investor believes in the expertise and human touch of a fund manager or team of professionals, then an actively managed fund like a mutual fund may be the right fit. While no one beats the market every year, some funds can potentially outperform the broader market for long stretches.
But for those individuals who want to invest in the markets and not think about it, then the broad exposure — and lower fees — offered by index funds may make more sense. Investing in index funds tends to work best when you hold your money in the funds for a longer period of time, or use a dollar-cost-average strategy, where you invest consistently over time to take advantage of both high and low points.
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The Takeaway
Index funds and mutual funds are similar investment vehicles, but there are some key differences which include how they’re managed, costs associated with them, and how they function at a granular level.
The choice between index funds and other mutual funds is one with decades of debate behind it. For individuals who prefer the expertise of a hands-on professional or team buying and selling assets within the fund, a mutual fund may be preferred. For investors who’d rather their fund passively track an index — without worrying about “beating the market” — an index fund might be the way to go.
Ready to expand your portfolio's growth potential? Alternative investments, traditionally available to high-net-worth individuals, are accessible to everyday investors on SoFi's easy-to-use platform. Investments in commodities, real estate, venture capital, and more are now within reach. Alternative investments can be high risk, so it's important to consider your portfolio goals and risk tolerance to determine if they're right for you.
FAQ
Do index funds outperform mutual funds?
Actively-managed funds, such as mutual funds, tend to underperform the market as a whole over time. That’s to say that most of the time, a broad index fund may be more likely to outperform a mutual fund.
Do people prefer index funds over mutual funds, or mutual funds over index funds?
The types of funds that investors prefer to invest in depends completely on their own financial situation and investment goals. But some investors may prefer index funds over mutual funds due to their hands-off, passive approach and lower associated costs.
Are mutual funds riskier than index funds?
Mutual funds may be riskier than index funds, but it depends on the specific funds being compared — mutual funds do tend to be more expensive than index funds, and tend to underperform the market at large, too.
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