Index funds vs. mutual funds: What’s the difference?

New investors often want to know the difference between index funds and mutual funds. The thing is, sometimes index funds are mutual funds and sometimes mutual funds are index funds. It’s like asking the difference between apples and sweet food. Apples can be sweet or sour, while sweet food includes more than just apples. So it is with mutual funds and index funds.

Here are the key features, as well as the pros and cons of mutual funds and index funds.

Index funds vs. mutual funds

Index funds and mutual funds both offer investors the chance to invest in a diversified collection of assets. Here’s how they stack up:

An index fund is a fund that invests in assets that are contained within a specific index. An index is a preset collection of stocks or bonds. The most well-known may be the Standard & Poor’s 500 Index, which includes the stocks of about 500 large American companies. An index fund merely mimics the assets in the index, making it a kind of passive investment, as opposed to trying to beat the index with active management.

A mutual fund is one way to structure an investment fund, and historically it’s been one of the most popular, though exchange-traded funds (ETFs) are growing very quickly. A mutual fund may include many kinds of assets or investment styles, including being an index fund or an actively managed fund. Literally thousands of mutual funds exist, and some of them are index funds.

As you can see, sometimes an index fund is a mutual fund, and sometimes a mutual fund is an index fund. So the “opposite” of a (passively managed) index fund is not a mutual fund but an actively managed fund. And one might say the “opposite” of a mutual fund is an ETF.

To say it another way, investors can buy an index fund that’s either an ETF or mutual fund. They can also buy a mutual fund that’s a passively managed index fund or an actively managed one.

The pros and cons of an index fund

An index fund can offer a number of pros and cons. Here are some of the most important.

Pros of an index fund

Low cost – Because they’re based on an index rather than actively managed, index funds tend to be much cheaper to own. The fund company doesn’t pay a pricey research staff to find the best investments but instead mechanically copies the index itself. So index funds usually charge a low expense ratio to investors.

May outperform active managers – Not all index funds are equal, but one of the best – the S&P 500 Index – outperforms the vast majority of investors in a given year and more over time.

Lower taxes – Index funds that are also mutual funds may create lower tax liabilities for investors because they have less turnover. This is mostly a non-issue for index ETFs.

Diversification – Because they’re comprised of a variety of assets, index funds can offer the benefits of diversification, reducing your risk as an investor.

Cons of an index fund

May track a poor index – Again, not all index funds are created equal, and an index fund may track a crummy index, meaning that investors get those crummy returns, too.

Delivers an average return – An index fund delivers the weighted average returns of its assets. It must be invested in all the index’s stocks, so it’s unable to avoid the losers. So while it may have very good years, it’s rarely going to have a barburner year.

The pros and cons of a mutual fund

A mutual fund can offer a number of pros and cons. Here are some of the most important.

Pros of a mutual fund

Can be low cost – Index mutual funds may be cheaper to own than a comparable index ETF, though many mutual funds are actively managed and therefore likely to be more expensive.

Diversification – Whether it’s focused on a sector or broadly invested, a mutual fund can offer you the benefits of diversification, including lower volatility and reduced risk.

May outperform the market – Actively managed mutual funds may outperform the market – sometimes stunningly so – but research shows that active investors rarely beat the market’s return over time. If the mutual fund is an index fund, though, it’s going to largely track the index’s performance.

Cons of a mutual fund

May have sales “loads” – A sales load is a fancy word for a commission, and the worst funds may charge 2 or even 3 percent of your investment, hitting your returns before you’ve invested a dime. It’s easy to avoid these fees by carefully selecting a fund.

May have a high expense ratio – If a mutual fund is actively managed, it likely charges a higher expense ratio than an ETF for all the analysts needed to sift through the market.

May underperform the market – Active management which is more typical in mutual funds tends to underperform the market average.

Capital gains distributions – At year-end, mutual funds may have to pay out certain capital gains for tax purposes. That means you could be on the hook for taxes, even if you didn’t sell a share of your fund.

Should you invest in these funds actively or passively?

Whether it’s the pros doing it or individual investors, active management tends to lead to underperformance. Passive investing is an attractive approach for most investors, especially because it requires less time, attention and analysis and still generates higher returns.

If you’re investing in an actively managed mutual fund, you want to let the manager do its job. If you’re trading in and out of the fund, you’re second-guessing professional investors that you’ve effectively hired to invest your money. That doesn’t make a lot of sense, and it can ring up capital gains taxes as well as fees for early redemption of your mutual fund.

Actively trading an index fund also doesn’t make a lot of sense, either. An index fund is by its nature a passively managed investment, so you’re buying the index to get its long-term return. If you trade in and out of the fund, even if it’s a low-cost ETF, you may easily lower your returns. Imagine selling in March 2020 as the market crumbled, only to watch it skyrocket over the next year.

Again, passive investing beats active investing most of the time and more so over time.

Bottom line

Index funds and mutual funds are not exclusive categories, though it can be easy to mistake them. So you can end up with stock index mutual funds, and often these stock funds are among the lowest-cost funds on the market, even more than the highly popular index ETFs. Regardless of how your fund is managed, investors will do better by passively managing their own funds.

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Original source: Bankrate