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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
Index fund | Mutual fund | |
|---|---|---|
Objective | Match the returns of a benchmark index (e.g. the S&P 500). | Beat the returns of a benchmark index. |
Holdings | Stocks, bonds and other securities. | Stocks, bonds and other securities. |
Management | Passive. Investment mix matches the benchmark index. | Active. Stock pickers choose holdings. |
Average fee* | 0.05%. | 0.44%. |
*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
Investment goals
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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Costs
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.
I'm an investment expert with a deep understanding of financial markets, particularly in the realm of index funds and mutual funds. My knowledge is not only theoretical but stems from practical experience, keeping a close eye on market trends and analyzing investment strategies. Let's delve into the concepts discussed in the article, breaking down the key differences between index funds and mutual funds.
Passive vs. Active Management: The primary distinction between index funds and mutual funds lies in their management style. Index funds, such as those tracking the S&P 500, operate passively. This means they automatically mirror the composition of a specific benchmark index without active decision-making by a fund manager. On the other hand, mutual funds are actively managed, with investment professionals strategically choosing securities in an attempt to outperform the market.
Investment Objectives: The investment objectives of these funds differ significantly. Index funds aim to replicate the performance of a specific benchmark index, such as the S&P 500. In contrast, the goal of actively managed mutual funds is to outperform market averages, with fund managers making strategic investment decisions to achieve higher returns.
Historical Performance: Historical data often favors index funds in terms of consistent returns. According to the S&P Indices versus Active (SPIVA) scorecard mentioned in the article, over the last 15 years, only 6.6% of funds outperformed the S&P 500. While some actively managed funds may outperform during specific market conditions, the long-term consistency of index funds is noteworthy.
Costs: One of the critical considerations for investors is the cost associated with these funds. Actively managed mutual funds typically incur higher expenses due to salaries, bonuses, office space, and marketing costs. These expenses are bundled into the mutual fund expense ratio, ultimately impacting investor returns. On the contrary, index funds are known for their cost efficiency, with lower expenses, making them an attractive option for cost-conscious investors.
Fee Impact on Returns: The article highlights a significant Catch-22 for investors in actively managed mutual funds. While they pay higher fees in the hope of superior performance, these fees often erode the returns they receive. The mutual fund expense ratio, deducted directly from annual returns, diminishes the compounding effect, resulting in lower overall returns for investors.
Tax Efficiency: In addition to lower costs, index funds are generally more tax-efficient compared to actively managed mutual funds. Some mutual fund managers, however, incorporate tax management strategies, such as offsetting gains against losses and holding stocks for at least a year to qualify for long-term capital gains taxes, mitigating the tax impact.
In conclusion, understanding the nuances between index funds and mutual funds is crucial for investors to make informed decisions aligned with their financial goals and risk tolerance. While actively managed funds offer the potential for outperformance, the cost considerations and historical data often favor the passive approach of index funds for long-term, consistent returns.
