Building a diversified investment portfolio can be a time-consuming task. Mutual funds and index funds can help save you time because they invest your capital across a variety of securities. However, there are some important differences that you need to understand before you invest.
What is a mutual fund?
Mutual funds invest in a variety of stocks, bonds, and other assets. They are like index funds but they try to beat the market rather than track it. The majority of these funds are actively managed and the fund managers pick the investments. Mutual funds can perform significantly better or worse than the market as a whole. Therefore, it’s important to choose a good fund manager if you want to invest in mutual funds.
Advantages of mutual funds
- Allows you to diversify across many companies and sectors.
- Can have higher gains, but only if it’s managed properly. You can sometimes outperform the market if you have a good money manager. Keep in mind though, very few investors actually outperform the market.
- There are a lot of different mutual funds to choose from.
- You can access your mutual funds whenever you want.
Disadvantages of mutual funds
- Higher fees than index funds.
- Requires more research to find the right fund (and fund manager).
- Riskier than index funds, as managers often try to beat the market by holding fewer securities.
- There is a capital gains liability. If you get a distribution from your mutual fund, you will be liable for capital gains tax on that distribution even if you reinvest it.
What is an index fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF). It aims to match the returns of a certain benchmark or stock index, such as the S&P 500 or Russell 2000. Index funds can reduce short-term capital gains because they aren’t constantly bought and sold by active managers.
The first step to investing in index funds is to decide which index you want to invest in. For example, if you purchase an S&P 500 index fund then that means that you have purchased a piece of the 500 largest companies listed on the New York Stock Exchange (NYSE) and Nasdaq. These funds are unlikely to perform better or worse than the benchmark that they follow.
Advantages of index funds
- Lower fees than mutual funds. The company doesn’t have to employ as many analysts for index funds, which means that the management fees are lower and you get to keep more of your gains.
- Allows you to diversify across many companies and sectors. Your investments will be spread across several sectors, which will reduce your risk.
- Works well for beginner investors because you can invest in index funds with minimal research.
- There is less tax liability. Index funds have less turnover than mutual funds which means that there is less tax liability.
Disadvantages of index funds
- Not actively managed by a professional so you will need to spend more time deciding what you want to invest in.
- No choice in who you invest in, which could be challenging if you take issue with a company’s business practices. You are investing in all of the stocks or bonds in the index so you can’t pick and choose which companies to invest in.
- Short-term gains are limited because you’re only invested in very small shares of each stock. The market as a whole also tends to move slower which means that you won’t see big gains in the short term.
What are the differences between index funds and mutual funds?
- Investment goals: The goal for index funds is to simply mirror the performance of an index. The goal of mutual funds is to try to beat the market. Investors who want to seek high returns may be more drawn to mutual funds.
- Active vs passive investment: Most, but not all, mutual funds are actively managed. This means that the fund manager will be making daily, sometimes hourly, trading decisions. Index funds are passive investments. The fund is tracking the performance of an index so there is no fund manager actively managing the index fund.
- Costs of investing: Both mutual funds and index funds make money by charging expense ratios. Expense ratios are charged based on assets under management. For example, if you invested $10,000 and your expense ratio is 2% then you would pay $200 for that fund. This will always change based on the value of your portfolio but it gives you an approximate amount that you can expect to pay. Mutual funds generally cost more than index funds. In fact, in some instances, mutual fund fees are 10x more than index funds. This is because mutual funds tend to have more expenses such as the fund manager’s salary, marketing, and other operating expenses.
Mutual funds vs index funds
|Mutual funds||Index Funds|
|Investment objective||Aimes to beat the returns of a benchmark index||Returns are based on a benchmark index, such as S&P 500|
|Types of investment||Stocks, bonds, other securities||Stocks, bonds, other securities|
|Management style||Fund managers pick the securities||They follow the index|
|Fees||Typically cost more than index funds||Typically less than mutual funds|
Do mutual funds outperform index funds?
More than 80% of stock mutual funds underperform their benchmark index fund over 10 years, according to S&P Dow Jones Indices. Mutual funds attempt to outperform the market, but achieving this is quite difficult. That said, some mutual funds manage to outperform. Mutual funds typically have higher fees than index funds. Even if your mutual funds do outperform index funds, after you pay the higher fees, you may be left with less money than if you invested in index funds.
Are index funds or mutual funds right for me?
As with any investment, the decision about which investment is better depends on what you want. If you are willing to take higher risks for a chance of a higher reward, then mutual funds may be right for you. If you prefer a less volatile investment, then index funds may be right for you. Before making an investment decision, consider your entire financial situation and think about your goals. Once you understand that, then you can think about the differences between mutual funds and index funds and make an informed decision about which option is right for you. Consider talking to a financial advisor if you want help deciding which type of fund to invest in.
Index funds and mutual funds can help you achieve your financial goals.
Index funds are great for hands-off investing and mutual funds may help you beat the market. It’s best to talk to your financial advisor about which approach may be best for you. If you want help with your finances and are interested in having a comprehensive financial plan, feel free to schedule a discovery call with one of our financial advisors today!
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.