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 resources that you should employ in your brokerage account, Roth IRA, TSP, or 401k.
In this side-by-side 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.
What is an Index Fund?
An index fund or exchange traded fund (ETF) are 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) is made up of the top 500 largest companies listed on the stock exchange. Similarly, an index fund tracks the returns of a market index, the Vanguard 500 Index Fund Investor Shares (VFINX) portfolio consists of the top 500 large-cap companies currently listed on the Stock Market.
Index funds are not strictly limited to market indices, they can also track a specific sector:
Financial Sector: Vanguard Financials ETF (VFH)
Insurance Sector: SPDR S&P Insurance ETF (KIE)
Cyber Security Sector: ETFMG Prime Cyber Security ETF (HACK)
Again, these are just a few examples of some sectors that are tracked by index funds.
There are literally thousands of index funds that exist to track very specific and detail oriented sectors.
Furthermore, index funds can even track international and global markets.
If you wish, your portfolio can be exposed to financial markets in Asia, Australia, India, or even Europe.
Index funds act identical to a stock. An investor can simply logon to their investment brokerage account and purchase or sell an index fund with ease, just as they would trade a stock.
Mutual Funds: Understanding the Basics
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. The selected professionals will invest in stocks, bonds, and other assets, which produce returns 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 the outlined parameters, they are free to do as they please.
Although mutual funds may seem appealing, they come with a higher-risk and a higher expense than an index fund.
Nonetheless, here is a list of the best-performing mutual funds .
What is the Difference between an Index Fund and a Mutual Fund?
As stated, index funds track a market index, while a mutual fund tries to outperform the market. The fundamental difference between an index fund and a mutual fund lies within the management structure.
Mutual Funds consist of a team of experts, portfolio managers, and industry professionals, who actively manage the invested money. Believe it or not, this team adjusts the fund daily, or in some cases, on an hourly basis. Which means, they are constantly trading in and out of stocks in hopes to outperform the overall market.
An index fund is essentially on autopilot, since no one is actively managing the fund. Performance of the fund is based off individual stock price movements. Index investing is a passive investment, so you as an owner, do not have to worry about portfolio management.
Index Funds vs. Mutual Funds: The Key Takeaway
The key takeaway is how much an index fund, or a mutual fund costs an investor.
Sadly, both index funds and mutual funds are not free. They both are accompanied with an expense ratio, which is another term for ‘fee.’
Mutual funds are actively managed. This means they are accompanied with a higher expense ratio. After all, you need to pay the team who is managing the fund, regardless if the mutual fund outperforms or under performs the market!
There are salaries to pay, monthly office space fees, bonuses, and employee benefits. Don’t worry, they don’t pay the cost, you do as a proud shareholder. As these expenses begin to pile up, your profit margin begins to dwindle.
As history reveals, it is incredibly difficult to outperform the market.
Currently, there is only handful mutual fund managers who do well over the course of the career, such as Peter Lynch (manager of the Fidelity Magellan Fund).
However, for every star manager there are numerous managers who failed, and lost countless investors their hard-earned money.
Which one is better to invest in?
I tend to keep my investment strategy and portfolio relatively straight forward.
I enjoy the freedom index funds provide investors and the low fees, which is why I own numerous in my investment accounts.
Before you invest, make sure you conduct thorough market research. Ultimately, it is your money, but why not spend the extra 5 minutes to ensure you make the best investment possible.
To truly take advantage of their capabilities, I employ our easy-to-follow dollar cost averaging strategy. This strategy minimizes my efforts, while simultaneously capitalizes on market pull backs. It is truly hands-off and allows me to focus on what matters in life: My family, friends, and hobbies.