Index Funds vs. Mutual Funds: What is the Difference?

Investing
June 22, 2020
Written by Drew Cheneler
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Investing
June 22, 2020
Written by Drew Cheneler
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Index funds vs. mutual funds: Index funds are low-cost investment vehicles which track a benchmark market index. Mutual Funds are actively managed by a team of professionals, who tried to outperform a benchmark market index.

As an investor, it is critical that you know the difference between an index fund and a mutual fund. Index Funds and Mutual Funds are great investment assets that all investors should own in their brokerage account, Roth IRA, TSP, or 401k.

In this comparison, we are going to dissect the fundamental differences between a standard index fund and a mutual fund. Now, index funds and mutual funds may seem like they are relatively similar, but they are not and here is why.

Index Fund: Everything You Need to Know

What is an index fund?

An index fund is designed to track a specific market index, such as the Dow Jones Industrial Average or the S&P 500 Index. To break this down further, the exposure in an index fund is directly proportional to the exposure in a market index.

For example, the Standard & Poor’s 500 (S&P 500), which is a large market index, is made up of the top 500 largest companies listed on the stock exchange. Like we stated earlier, an index fund tracks the returns of a market index – such as the Vanguard 500 Index Fund Investor Shares (VFINX). This index fund consists of the top 500 large-cap companies currently listed on the stock market and is designed to match the performance of the S&P 500 market index.

Index funds are not strictly limited to market indices, they can also track a specific sector. For Example:

  • Financial Sector: Vanguard Financials ETF (VFH)
  • Insurance Sector: SPDR S&P Insurance ETF (KIE)
  • Cyber Security Sector: ETFMG Prime Cyber Security ETF (HACK)

Again, there are literally thousands of index funds that track specific sectors, these are just a few that came to mind.

Don’t worry, index funds also track global markets, so if you want exposure to financial markets in Asia, Australia, India, or even Europe, there are index funds to do this. If you are interested in learning more, then sign-up for a Morningstar account. They are the go-to resource for serious investors who want to make smart and calculated financial investments.

Management Structure of an Index Fund

Considered a passive investment, index funds are largely automated due to technology. Since they are not actively managed, index funds usually come with a cheaper expense ratio allowing you to profit more.

What are Index Funds invested in?

Index funds invest in a wide variety of securities. However, index funds tend to invest in stocks, bonds, real estate, and other securities it is predetermined to track.

What is the Investment Goal of an Index Fund?

Perform on par with the market index being tracked. However, depending on which index fund you purchase it is not uncommon for the fund to outperform (do better) than the market index it is designed to track.

What is the Average Expense Ratio of an Index Fund?

Traditionally, the expense ratio is between 0.09% – 0.11%.

Who are index funds best for?

As you can see, index funds are best for individuals who are fine doing a little bit of market research. Though this may require a certain level of time commitment, index funds come with a lower expense ratio, which means your level of profitability increases substantially.

Mutual Funds: Understanding the Basics

What is a Mutual Fund?

Mutual funds are made up of a pool of money, which is collected from hundreds or even thousands of investors. These funds are operated by professional’s who will invest in stocks, bonds, and other assets with the end goal of producing a favorable return for their investors.

Unlike a simple index fund, the portfolio and investment strategy in a mutual fund has to match the objectives outlined (charter) by the team of professionals who manage the fund.

So, they are free to shop around the market to pick individual stocks, invest in alternative assets, or even bonds. As long as the management team stays within their outlined parameters, they are free to do as they please.

Although mutual funds may seem appealing, they come with more risk and a higher expense ratio. Evidently, the average expense ratio for an index fund is anywhere between 0.80% – 1.0%. This may not seem like a lot, but overtime this can and will equate to literally thousands of dollars which could of been yours if you decided to invest in standard index funds.

Management Structure of Mutual Funds

Actively Managed. A team of professional’s decide what to invest in. They have total discretion over which assets to invest in and which ones to avoid. This discretion is often why mutual funds are accompanied with a higher expense ratio.

What does it invest in?

Mutual funds invest in bonds, stocks, and alternative assets to generate returns. Again, the portfolio manager has complete control over which assets to invest in.

Mutual Funds Investment Goals

The investment goal of a mutual fund is to outperform the broader stock market. As we know, the market has a historical average of returning close to 8.0%, so if the manager returns anything higher then they exceeded their initial investment goal.

What is the Average Expense Ratio of a Mutual Fund?

Since mutual funds are actively managed they command a higher average expense ratio. Typically, they will charge 0.80% – 1.0%.

Who Are Mutual Funds Best For?

Though mutual funds come with a higher expense ratio, they are still a great choice for everyday investors. Mutual funds are best for investors who want to remain hands off and leave the stock picking to a seasoned team of professionals. Like all investment strategies, you want to ensure you consider all risks and expenses.

Index funds vs. Mutual Funds: Final Thoughts

At the end of the day, we all have unique financial goals, different tolerances for risk, and a budget. By now, you can see that the biggest difference between an index fund and a mutual fund is their price. Undeniably, an index fund is cheaper; however, a mutual fund comes with a team of professionals who will actively manage the fund.

Regardless if you choose an index fund or a mutual fund, make sure you account for the expense ratio, conduct market research, and speak to others who actively invest. Often times, hearing a perspective from a family member or friend is enough to validate your investment decision.

Drew Cheneler
Drew Cheneler
Drew is a recognized Credit, Small Business, and Personal Finance Expert. He has been quoted in CNBC, The Huffington Post, Business.com, Moneyunder30, and more. He is known for breaking down complex personal finance topics into action-oriented advice, so you can make the most of your hard-earned money.