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The biggest difference between index funds and mutual funds is that index funds invest in a specific list of securities (such as stocks of -listed companies only), while active mutual funds invest in a changing list of securities, chosen by an investment manager.
Over a long-enough period, investors might have a better shot at achieving higher returns with an index fund. Exploring these differences in-depth reveals why.
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Index fund vs. mutual fund
Match the returns of a benchmark index (e.g. the S&P 500).
Beat the returns of a benchmark index.
Stocks, bonds and other securities.
Stocks, bonds and other securities.
Passive. Investment mix matches the benchmark index.
Active. Stock pickers choose holdings.
*Asset-weighted averages from 2022 Investment Company Institute data
Differences between mutual funds and index funds
Passive vs. active management
One difference between index and regular mutual funds is management. Regular mutual funds are actively managed, but there is no need for human oversight on buying and selling within an index fund, whose holdings automatically track an index such as the S&P 500. If a stock is in the index, it’ll be in the fund, too.
» Learn more: How to invest with index funds
Because no one is actively managing the portfolio — performance is simply based on price movements of the individual stocks in the index and not someone trading in and out of stocks — index investing is considered a passive investing strategy.
In an actively managed mutual fund, a fund manager or management team makes all the investment decisions. They are free to shop for investments for the fund across multiple indexes and within various investment types — as long as what they pick adheres to the fund’s stated charter. They choose which stocks and how many shares to purchase or punt from the portfolio.
» Ready to get started? See how to invest with mutual funds
If you can’t beat ‘em, join ‘em. That’s essentially what index investors are doing.
The sole investment objective of an index fund is to mirror the performance of the underlying benchmark index. When the S&P 500 zigs or zags, so does an S&P 500 index mutual fund.
The investment objective of an actively managed mutual fund is to outperform market averages — to earn higher returns by having experts strategically pick investments they think will boost overall performance.
» Learn more: Understand the different types of mutual funds.
History has shown that it’s extremely difficult to beat passive market returns (a.k.a. indexes) year in and year out. According to the S&P Indices versus Active (SPIVA) scorecard, only 6.6% of funds outperformed the S&P 500 in the last 15 years.
That being said, there are some fund managers that do beat the market, when the conditions are right. The scorecard says in the past year, 48.92% of funds have outperformed the market. How? Think about the rocky landscape of 2022; some of the top companies in the S&P account for a big part of that index, and those companies have seen some declines.
If you choose active management, particularly when the overall market is down, then you might have the opportunity to make higher returns, at least in the short term.
Instead of tracking an index, a fund manager could seek to diversity your portfolio a bit more, by buying value stocks, or asset weighting toward other companies.
But in exchange for potential outperformance, with an actively managed fund, you’ll pay a higher price for the manager’s expertise, which leads us to the next — and perhaps most critical — difference between index funds and actively managed mutual funds: Cost.
» Prefer actively managed? Best performing mutual funds
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As you can imagine, it costs more to have people running the show. There are investment manager salaries, bonuses, employee benefits, office space and the cost of marketing materials to attract more investors to the mutual fund.
Who pays those costs? You, the shareholder. They’re bundled into a fee that’s called the mutual fund expense ratio.
And herein lies one of the investing world’s biggest Catch-22s: Investors pay more to own shares of actively managed mutual funds, hoping they perform better than index funds. But the higher fees investors pay cut directly into the returns they receive from the fund, leading many actively managed mutual funds to underperform.
» How do fees impact returns? This mutual fund fee calculator can help
Index funds cost money to run, too — but a lot less when you take those full-time Wall Street salaries out of the equation. That’s why index funds — and their bite-sized counterparts, exchange-traded funds (ETFs) — have become known and celebrated for their low investment costs compared with actively managed funds.
» Examine the cost: Mutual fund fees investors need to know
But the sting of fees doesn’t end with the expense ratio. Because it's deducted directly from an investor’s annual returns, that leaves less money in the account to compound and grow over time. It’s a fee double-whammy and the price can run high.
Index funds also tend be more tax efficient, but there are some mutual fund managers that add tax management into the equation, and that can sometimes even things out a bit.
These mutual fund managers can offset gains against losses, and hold stocks for at least a year, resulting in long-term capital gains taxes, which are generally less expensive than short-term capital gains taxes.
» Check out the full list of our top picks for best brokers for mutual funds.
As an expert in the field of investment and financial planning, I bring years of hands-on experience and a deep understanding of various investment instruments. My expertise is grounded in a thorough knowledge of market dynamics, investment strategies, and the nuances of different financial products. Allow me to demonstrate my proficiency by dissecting the concepts presented in the article you provided.
The article compares index funds and mutual funds, emphasizing the differences in their investment approach, objectives, and management styles. Let's delve into the key concepts mentioned:
Index Fund vs. Mutual Fund:
- Index Fund: Aims to match the returns of a benchmark index (e.g., S&P 500).
- Mutual Fund: Strives to beat the returns of a benchmark index.
- Index Fund: Holds stocks, bonds, and other securities that mirror the components of a specific index.
- Mutual Fund: Holds a dynamic list of securities chosen by a fund manager, including stocks, bonds, and other securities.
- Index Fund: Passive management with holdings automatically tracking the selected index.
- Mutual Fund: Actively managed, with investment decisions made by a fund manager or management team.
Passive vs. Active Management:
- Index Fund (Passive): Follows a predetermined index without active decision-making. Performance is based on the price movements of index components.
- Mutual Fund (Active): Actively managed by fund managers who make investment decisions, choosing securities across various indexes and investment types.
- Index Fund: Aims to mirror the performance of the underlying benchmark index.
- Mutual Fund: Seeks to outperform market averages and achieve higher returns through strategic investment decisions.
- Index Fund: Generally has lower costs due to passive management, with lower expenses for salaries, bonuses, and marketing.
- Mutual Fund: Involves higher costs, including investment manager salaries, bonuses, and marketing expenses, leading to a higher mutual fund expense ratio.
Fee Impact on Returns:
- Investors pay more in fees for actively managed mutual funds, impacting overall returns.
- Index funds, with lower expenses, are known for their cost-effectiveness and potentially higher returns after accounting for fees.
- Index funds are often more tax-efficient due to their passive nature.
- Some mutual fund managers incorporate tax management, offsetting gains against losses and potentially mitigating tax impact.
In conclusion, the article provides a comprehensive overview of the distinctions between index funds and mutual funds, highlighting the impact of management styles, investment goals, and costs on investor returns. As an enthusiast with a wealth of knowledge in investment strategies, I encourage individuals to consider these factors carefully when making investment decisions.