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.
This article will outline the distinctions between the two types of investment funds, and touch on the benefits of an index fund vs. mutual fund, and vice versa. We’ll cover the following topics:
• What’s the Difference between Index Funds and Mutual Funds?
• Index vs Mutual Funds: A History
• Index vs Mutual Fund Fees
• ETFs, Index Funds, and Mutual Funds
• Index Vs. Mutual Fund: Which is Best for You?
What’s the Difference between Index Funds and Mutual Funds?
The short version is that index funds are, in fact, a type of mutual fund. 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.
How Do Mutual Funds Work?
Because index funds and mutual funds share a common background, it may make sense to explain what a mutual fund is first. 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.
How Do Index Funds Work?
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.
Index vs Mutual Funds: A History
For many decades, the idea of a star portfolio manager or management team was behind the most successful mutual funds. This philosophy of stock picking, and sometimes bond picking—also called active investing—drove the mutual fund business.
But starting in the 1970s, people started to look past the ongoing horse race of hotshot mutual fund managers to the indexes. Investors already knew that one way to assess how well an active manager was doing was to compare them to an index.
Here’s how the comparison typically worked: Say, for example, an investor wants to invest in large, U.S. companies. They might compare the performance of a mutual fund that invests in those companies with the performance of the S&P 500, which consists of the NYSE- or NASDAQ-traded stocks of 500 of the largest companies. If the fund has done better than the index, then that should be an indication that the fund manager or management team knows what they’re doing when it comes to investments.
In 1975, a man named John Bogle launched the First Index Investment Trust, which was by many accounts the first index mutual fund available to the public. It invested in every stock in the S&P 500. And thus, index investing was born.
The fund, which eventually became known as Vanguard 500 Index Fund, kicked off a larger movement towards index funds. In fact, it’s fair to say that index funds have transformed mutual fund investing. On August 31, 2019, the shift reached a watershed moment. On that date, index mutual funds reached $4.27 trillion in investor assets under management, according to research firm Morningstar Inc. This was significant, because it meant they managed more investor funds than actively managed mutual funds, which had $4.25 trillion invested in them.
Index vs. Mutual Fund Fees
When it came down to index vs. mutual funds, John Bogle and other proponents of index funds mentioned the fees first and foremost. Mutual-fund managers 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.
Currently, an actively-managed mutual fund charges an expense ratio (which includes the management fee) of 0.5% to 0.75% (though they may be as high as 1.5%). But for index funds, that expense ratio is around 0.2% and as low as 0.02% for some funds.
Those are the numbers. This is the argument: Performance will vary from year to year, but investors can control the fees they pay. And over time, the difference those fees make may matter more than the difference in performance.
Index Fund Performance
At the same time, market performance has vindicated index funds in many ways. The most notable example was in 2006, when longtime mutual-fund portfolio-manager champion Bill Miller and his legendary Legg Mason Value Trust failed to beat the S&P 500 index for the first time in 15 years.
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So, while the fortunes of star managers rose and fell through the booms and busts of the early 200s, the 2008 financial crisis, and the subsequent bull market, the low fees offered by index fund providers remained low.
ETFs, Index Funds, and Mutual Funds
But there was another factor that played into the general trend. That was the invention, and widespread adoption of exchange traded funds (ETFs). These are similar to a traditional mutual fund in many ways, but there’s a key difference—an ETF offers shares that trade on a public exchange, and whose prices fluctuate throughout the day.
Because the shares of ETFs trade constantly on an exchange, having an active manager is complicated. There are actively managed ETFs, but they’re relatively new, and still considered a niche investment. Most ETFs are index funds.
Since their launch, ETFs have become a go-to investment vehicle for a wide range of investors, from long-term investors saving for retirement to hair-trigger institutional asset managers overseeing massive portfolios. For the former, they offer extremely low fees. For the latter, they offer quick access and liquidity when moving into and out of different sectors, sub-sectors and regions in the global equity markets.
Index Vs. Mutual Fund: Which is Best for You?
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.
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.
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