Index funds are a type of mutual fund that usually aims to track the performance of a market index, like the S&P 500. Some other mutual funds use other strategies to attempt to outperform popular market indexes.
What’s the Difference Between Mutual Funds and Index Funds?
Both mutual funds and index funds can be good choices for investors who want an easy way to build a diversified portfolio, as these funds tend to own dozens, hundreds, or thousands of different securities.
Investing Strategy
Investing strategy is where mutual funds and index funds differ, however. Index funds are a type of mutual fund with a specific investment strategy that aims to match the performance of a specific market index as closely as possible. For example, if you invest in an S&P 500 index fund, it will try to mimic the performance of the S&P 500. When the S&P gains 1% in value, for example, the fund will aim to gain 1%. If the S&P loses 1%, the fund’s trading activity should result in a loss of about 1%. Often, index fund managers do this by trying to match their portfolio compositions to the composition of the index itself. There are many other types of mutual funds beyond index funds. Each can have a different investment strategy. Some funds are actively managed, with managers who try to buy stocks they think are poised to gain value and to sell stocks when their price is high. Others focus on specific types of stocks, such as blue chips or growth stocks. Yet others invest in non-stock securities such as bonds or derivatives. There are funds for almost any investment strategy and goal, including international investing, emerging markets, investing in a specific sector, socially responsible investing, and more. Each strategy will bring its own risks and rewards.
Costs
Index funds are a type of passively managed mutual fund. The fund managers build a portfolio that mimics that of the index the fund aims to track, then work to maintain that portfolio. By contrast, managers at actively managed funds spend a lot of time researching investment opportunities and trying to find beneficial times to buy and sell. Passive management is much easier, and therefore less expensive than active management. This means that passively managed funds, like index funds, are much cheaper to invest in than actively managed funds. On average, the expense ratio of a passively managed fund, such as an index fund, was 0.13% in 2019 compared with 0.66% for actively managed funds, equivalent to a savings of $5.30 per year for every $1,000 invested, according to investment research and management firm Morningstar.
Tax Liability
Mutual funds distribute capital gains to investors who own shares, and those investors must pay capital gains taxes on distributions they receive. The more transactions a fund manager makes, the more potential opportunities there are for the fund to realize gains and pay those gains out to investors. Index fund managers, by contrast, tend to make fewer transactions, meaning index funds will usually realize fewer gains. That means that index funds can create less tax liability for investors in the short term.
Which Is Right for You?
In general, it’s usually better to choose an index fund over a more expensive, actively managed fund. Actively managed mutual funds have higher investment costs, which means the fund manager must not only outperform the market, but outperform it by enough to overcome the impact of the additional fees charged. Studies have shown there are very few fund managers who can beat the market over the long term, especially when adjusting for fees. Investing in mutual funds with specific strategies can be helpful for investors who want to add a very precise selection of stocks, such as companies in a specific industry, to their portfolios. Most long-term investors, however, will be happy with an index fund.
Mutual Funds vs. Index Funds Example
Assume you invest $100,000 in two mutual funds. One is a passively managed index fund, the other is an actively managed fund that tries to beat the market. The index fund charges the industry-average expense ratio of 0.13%. The actively managed fund charges the industry average 0.66%. If both funds earn a return of 10% in one year, after accounting for fees, your balance in each will be:
Index fund: ($100,000 + ($100000 * 10%)) * (100% - 0.13%) = $109,998.57Actively managed mutual fund: ($100,000 + ($100,000 * 10%)) * (100% - 0.66%) = $109,992.74
While the difference at first seems slight, over the long term, the impact can be significant. Over the course of 30 years, the additional 0.53% in fees paid for the actively managed fund would cost you $227,416.16, assuming both funds continued to return 10% per year. To provide the same returns, the active fund’s manager would need to beat the index fund’s performance by 0.53% every year, which is a significant amount.
The Bottom Line
Index funds are a type of mutual fund that focuses on mimicking a portion of the market rather than trying to outperform the market. They usually have lower management fees than actively managed mutual funds, which can make them a solid choice for investors who aren’t looking for a fund with a specific strategy, such as honing in on a particular type of stock or sector.
The Balance does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future performance. Investing involves risk, including the possible loss of principal.
