No matter where you are on your financial journey, choosing between mutual funds and index funds is not so easy. Conceived as multi-asset baskets, both index funds and mutual funds offer a diverse pool of investments that can either be actively or passively managed.
Yet, very few people know the differences between them. Given that both are collective investment vehicles—most investors, especially those who are still at an early stage of their investment journey, feel daunted in front of two similar financial instruments.
To get started, you need to have a clear understanding of what these funds are and what it takes to invest in them.
Just the Nuggets
- Three main aspects differentiate an index fund from a mutual fund: who determines which type of investments the fund should hold, the fund’s investment objective, and the amount investors can pay to own it.
- Essentially, from an investor’s standpoint, the most important characteristic is cost.
- Mutual funds are generally actively managed to buy or sell assets within the fund, aiming to beat the market trend and to generate a high return on investment.
- Before opting for one or another investment option, it is vital to consider the tax implications and fee structures of the index or mutual fund.
Mutual Funds at a Glance
A mutual fund consists of a pool of money collected from numerous investors seeking to generate profit from investing in securities such as stocks, bonds, foreign exchange, and other instruments.
Mutual funds are operated by fund or money managers, who allocate the fund’s assets with the main purpose to produce capital gains for investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives outlined in its prospectus.
As a shareholder in a fund, you participate proportionally in gains or losses. Mutual funds invest mostly in securities, and performance is appreciated as the change in the total market cap value of the fund derived by the aggregated performance of the underlying investments.
Essentially, a mutual fund’s value is dependent on the performance of the securities it decides to buy. When you buy a unit or a share of a mutual fund, you buy the performance of its portfolio or rather, a part of its portfolio’s value. This is why investing in a share that is part of a mutual fund is fundamentally different from investing in shares of stock.
The price of a mutual fund is generally referred to as Net Asset Value (NAV) per share or NAVPS.
NAV is calculated by dividing the total value of the securities in the portfolio by the total amount of outstanding shares (shares held by all shareholders, including institutional investors, company officers, and insiders).
You can always buy or redeem mutual fund shares at the fund’s current NAV, which does not fluctuate during market hours but is settled at the end of each trading day instead.
Advantages of Mutual Funds
Investing in mutual funds has a lot of advantages.
1. Low-cost portfolio diversification
An average mutual fund holds hundreds of different securities. For investors, this is a very important aspect as it allows them to achieve portfolio diversification while spending less.
For example, if you buy Google stock and the company then reports major quarterly losses, you stand to lose a great deal because your whole capital is tied to a single company. Whereas if you buy shares in a mutual fund, your risk is spread across a multitude of asset classes, and the portion of capital you lose is a lot lower compared to the whole because Google accounts only for a small part of your portfolio.
2. Higher profits
Investing in a mutual fund rather than a simple stock gives you a distinct advantage. For instance, buying Google stock gives you an ownership right over a portion of the company’s assets. Similarly, investing in a mutual fund gives you an ownership right over the mutual fund company and its assets.
The major difference is that Google is in the business of software development while a mutual fund company is in the business of generating investments and hence, profits.
3. More income streams
As a fund owner, you will receive virtually all the income the fund generates within the year in the form of a distribution, which is typically the sum of any stock dividends or interest on bonds included in the portfolio.
Often, funds give their investors the choice either to receive a check for distribution or to reinvest their earnings and get more shares instead. It’s a win-win, no matter how you look at it!
4. More flexibility
If the fund holdings rise in price but the fund manager does not sell them—as an investor, you can and should sell your mutual fund shares for a profit in the market.
Disadvantages of Mutual Funds
Nevertheless, investing in mutual funds is not without risk. Here is what you may need to consider before you make any move.
1. Advertising fees and sales charges
Always pay attention to investment costs. Ideally, refrain from investing in funds with an expense ratio above 1.20%, as they are generally considered to be on the higher cost end. Similarly, be cautious of any advertising fees and sales charges, such as management fees and the like. All these types of charges lower the overall investment returns.
2. Management abuses
Excessive trading (in an attempt to replace the losers in the portfolio before quarter-end to balance the books), churning, and other similar techniques could deter your efforts.
3. Tax inefficiency
Turnover, redemptions, gains, and losses in security holdings throughout the year make it impossible for investors to keep track of what each distribution should include to be tax-efficient.
4. Weak execution strategy
If you place a mutual fund trade before the cut-off time for same-day NAV, for example, you will receive the same closing price NAV for your sell or buy position on the mutual fund.
Nevertheless, if you are a day trader and are looking for near-term gains, then that is a completely different ball game. Generally, the faster the execution, the weaker your investment performance will be. Strategies like day trading or market timing do not work with mutual fund investments.
Despite these shortcomings, mutual funds remain a top choice for most investors these days.
Could it be the stock market rally amid the current COVID crisis spurring this investment flurry?
While this may or may not be the only reason, one thing is certain—there are as many types of mutual funds as investors are risk-hungry.
Types of Mutual Funds
Setting out on the financial markets can be daunting and bewildering especially to beginners. With so many options at hand, it’s becoming harder and harder to make the right investment choice.
One thing is certain though. Mutual funds can be cost-effective and, depending on the type of fund, offer really good portfolio diversification. Here are some of the commonly known types of mutual funds.
Active Mutual Funds
These are baskets of securities managed by an investment/fund management company or a fund manager on behalf of investors who lack the time, expertise, or resources to buy a diversified pool of securities on their own. In exchange for their services, the fund may charge fees of 1% or more of the invested amount per annum. For example, if you invest $10,000, you will have to pay $100 in fees.
Active mutual funds fall into different categories, depending on the types of securities they include:
- equity funds (usually the stock-based funds—which can be small, medium, and large-cap equities—depending on the market segment they track)
- fixed-income funds (bond funds)
- money market funds (consisting of risk-free, short-term debt instruments such as Treasury Bills)
- income funds
- balanced funds
- global funds
Of all the fund types, equity fund is the largest and riskiest category as it includes stocks. What is of core importance when it comes to equity funds is their purpose. This is why you will often hear brokers or fund managers speak about aggressive growth, income-oriented, value, and others.
Equity funds are further classified into domestic (US) stocks or foreign equities. Sometimes equity funds are also referred to as value funds. Value funds seek to generate profit from investing in high-quality, low-growth company stocks.
This type of fund seeks to invest in undervalued bonds to sell them later for a profit.
Fixed-income mutual funds are generally considered safer for investors looking for steady gains, as they focus on investments paying a set return rate such as government bonds, corporate bonds, and other debt instruments. The bond-based portfolio practically generates interest, which is then paid to shareholders.
In comparison to equity funds, bond funds generate higher returns. Despite their more stable nature, bond funds are subject to interest rate risk.
Income funds are generally more conservative and hence, more appealing to less risk-taking investors or retirees.
Investing in high-quality government and corporate debt, income funds hold these bonds until maturity to generate interest streams. Although the fund’s underlying assets may appreciate in time, the main purpose of the fund is to provide steady cash flow to investors rather than high or spontaneous profits.
Yet if you are a tax-conscious investor, you might not opt for income funds simply because the interest earned would also be a tax burden for you at the end of the term.
If you’re looking for a diversified portfolio, balanced funds are a great choice. Investing in hybrid asset classes including stocks, bonds, money market instruments, and alternative investments—the goal is to level out the risk exposure across multiple asset classes.
Depending on the strategy they use, they fall into two categories:
- fixed allocation strategy funds (with predictable risk exposure to various asset classes)
- dynamic allocation strategy funds (allowing the portfolio manager to adjust risk exposure on the go to maintain portfolio stability)
Money Market Funds
Money market funds are in a way a safe investment, as they are focused on Treasury bills (T-bills).
T-bills are short-term US government debt obligations backed by the Treasury Department with a maturity of one year or less. T-bills are usually sold in denominations of $1,000.
A typical return would be a little bit more than what you would normally receive in a savings account and a tad bit less than what you would normally get with a certificate of deposit (CD).
Global funds invest in a wide range of asset classes across multiple markets. Being so diverse, it’s extremely difficult to classify these investments as safer or riskier than domestic investments.
Sensitive to every political and socio-economic shift, global funds are notoriously volatile. Yet, this doesn’t mean they cannot be included in a balanced portfolio where they can provide great diversification.
This type of fund forgoes categorization to channel investments into a specific sector of the economy or strategy.
Sector funds are targeted strategy funds aimed at gathering capital to boost certain economic sectors, such as healthcare, technology, education, finance and business, banking, etc.
Regional funds focus on specific geographic areas, aiming to boost them economically. The main advantage of regional funds is, you can easily buy stock in different countries around the globe.
Index Funds at a Glance
Active management is not the only way to manage a fund. There is also a lot of talk about passive management or passive index funds.
Unlike mutual funds, passive or index funds do not trade frequently. Instead, they just buy and hold the stocks; they do not need to be managed by a fund manager, nor do they require the involvement of a market analyst or research company to vigilantly watch the performance of each company stock that is part of the index.
Hence, the investment cost you could incur with an index fund is significantly lower compared to that of a mutual fund. Depending on the financial firm offering investments in index funds, you could be charged as little as 0.2% or $2 annually for a $10,000 investment.
With index funds, you get to own all the stocks making up the basket and hence, earn an average return of all the stocks in that market. While investing in index funds arguably increases your exposure to a certain market—when it comes to gains, the question is: would you settle only for average returns and performance?
You must have heard about the Standard & Poor’s 500 Index of large-company stocks and the Russell 2000 Index of small-company stocks.
The goal of these indices is to mirror the performance of the entire market segment they represent. Investing in any of these indices will offer you sizable exposure to each of the respective sectors and hence considerable returns.
According to investment researcher Morningstar, less than 1 in 10 actively managed blue-chip stock funds have outperformed index funds over the last 10 years. Interestingly, only roughly 20% of the small-cap stock funds have proven successful, Morningstar suggests.
Advantages of Index Funds
Index funds are well known for offering broad diversification, low-cost investments, and substantial returns.
1. Broad diversification
The most important and clear advantage of index funds is that your portfolio becomes diversified from the first investment, thus reducing the chances of you losing money.
For example, the S&P 500 Index invests in 500 different stocks. Their performance will fluctuate over time. But if your investment is spread across this multitude of assets, you are cushioned against all these ups and downs.
By comparison, if you park your money in two or three stocks thinking that their price will go up and instead it goes down, you lose your entire capital. Whereas if you invest in an index, if one or two stocks are in the red and the rest are performing well, that loss will not wipe out your entire portfolio.
2. Low cost
The expense ratio or annual fees that investors pay for owning a portion of those index funds is usually a percentage of the total invested assets.
This ratio for index funds varies between 0.05% and 0.07%, while some even charge 0.03%. For example, if you invest $100,000 in a fund with an expense ratio of 0.03%, you will pay only $30 per year.
Comparatively, if you invested the same amount in a mutual fund with an expense ratio of 1%, that is a lot less ($100,000 x 1:100 = $1,000).
3. Substantial returns
Statistically, only 23.51% of the actively managed funds outperform the S&P 500 in five years, experts at Standard & Poor’s say.
Index funds have broadly high returns and low cost, which makes them an excellent investment choice for every seasoned investor looking to diversify their portfolio cost-effectively.
Disadvantages of Index Funds
However, you cannot assume that index funds come with no risks at all. Some of the disadvantages are:
1. Lack of flexibility
Index funds are arguably less flexible than non-index funds, and hence their reaction to price declines in the securities making up the index is less spectacular.
So if you are hoping for more sensitivity to market volatility, perhaps, index funds are not the best choice.
2. Tracking error
Although it is said to track the performance of a specific index, an index fund may sometimes fail to perfectly do that.
For example, a fund may only invest in a selection of the securities found in the market index, in which case the fund’s performance will be less likely to match the performance of the actual index.
It is not uncommon for an index fund to underperform its index because of the fees, trading costs, and tracking error.
Types of Index Funds
Since index funds seem to tick off all the points on an investor’s checklist from cost to returns, you need to know the two types of index funds: index mutual funds like the Vanguard 500 Index Fund and exchange-traded funds or ETFs like the SPDR S&P 500. While both may yield similar benefits, they are structured differently.
Index Mutual Funds
Index mutual funds are typically available in mutual fund companies, such as Vanguard, Charles Schwab, Fidelity, to name a few of the most well known in the industry.
Brokers also offer index mutual funds. The difference between these and benchmark index funds is in fees and trading terms they’re subjected to.
Exchange-Traded Funds (ETFs)
With a mutual index fund, you buy or sell shares from the fund company directly, whereas ETFs are not sold directly by the fund company. They are listed on an exchange, and you need to have a brokerage account to buy or sell ETF shares.
Unlike mutual index fund shares that can be traded once a day only based on the 4 p.m. closing price, ETFs can be traded according to market schedule and are generally more costly, since you have to pay a commission every time you buy or sell.
Long-term investors feel this cost more acutely than others. In recent years, brokerage firms have started a price war with most of them offering commission-free trading on stocks and ETFs. For investors, this translates to greater freedom of choice and the extra convenience of buying and selling at any time of day, at no additional cost. However, ETFs are sophisticated instruments requiring both skill and in-depth market knowledge.
Mutual Fund vs. Index Fund: Which is Better?
Both mutual and index funds offer great portfolio diversification. Depending on your risk appetite, investing potential, and medium to long-term goals, you may opt for one or the other.
For example, if you are a more adventurous and seasoned investor with in-depth knowledge about the financial markets and key drivers and also have anywhere between $10,000 to $50,000 at your disposal, index funds or ETFs will likely satisfy your demands.
Comparatively, mutual funds are an excellent choice for high-net-worth investors looking to diversify their portfolios with no hassle.
Character Traits of an Index Fund Investor
What does it really take to invest in index funds? Are index funds investors different?
A lot of ink has been spilled on behavioral finance and how psychology can either make or break an investor’s experience. For every investor, there’s a suitable investment. And index funds in particular are highly versatile, rewarding, and also complex instruments calling for a particular type of investor.
Typically, index fund investors are:
1. Calculated and technical
They study the markets meticulously and always pay attention to the numbers. They are “obsessed” screen-watchers, eagerly anticipating the next swing.
Index fund traders don’t react on impulse. It’s just them and the charts. The only things that matter are the data and the facts at hand. This is how they weigh their possibilities and plan the next move.
These investors do their homework conscientiously. No macroeconomic data release, no economic event that could impact the performance of their benchmark index passes by them.
They rely on their own knowledge and navigate the markets with the confidence of a market mind-reader. They are not afraid to take risks and anticipate the next trend.
5. Versatile and relentless
Index fund investors have the unique ability to wear many hats. They can easily adapt to any market conditions. No sudden shift in trend or market tempest abates them from their path.
Index fund investors often hold a brokerage account for their investments.
Character Traits of a Mutual Fund Investor
Mutual fund investors are typically high and ultra-high-net-worth individuals with little time to sit in front of the charts. Looking for cost-effective yet quick portfolio growth and diversification, they will turn to a portfolio manager to handle their investments. They typically are:
1. Meticulous and calculated
They carefully study the offers of five to six mutual fund investment firms, read reviews, and be extremely cautious about any associated fees.
They study the markets and tend to look for opportunities where nobody else can find any. Mid-cap markets are constantly on their radar.
Mutual fund investors look for high diversification through greater market exposure to large-cap markets. Rapid-growth companies will be on their menu as well.
They tend to check in regularly with their portfolio or fund manager to see how well their portfolio is performing.
Typically, mutual fund investors will trust a top-tier investment firm or investment bank with their funds.
In a nutshell, both mutual funds and index funds are beneficial for a well-balanced portfolio. Yet the differences between the two forms of investment are essential.
Here is what you need to keep in mind before choosing one or the other.
|MUTUAL FUND||INDEX FUND|
|Objective||Outperform a related benchmark index||Match the performance of a benchmark index. |
As the saying goes, “If you can’t beat’ em, join ‘em.”
|Portfolio||Invests in stocks, bonds, treasury bills, and other securities||Invests in stocks, bonds, and other securities|
Fund/portfolio managers select the securities and trade them on behalf of investors.
Investments are automatically matched to meet the performance of the benchmark index.
|Average expense ratio (management fee)||0.82%||0.09%|
|Fees paid over 30 years||$18,000||$1,500|
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