What we'll cover
How mutual and index funds work
Difference between mutual funds and index funds
The pros and cons of mutual and index funds
Deciding whether you want to invest in mutual funds or index funds may seem like a really tough decision, like deciding between your favorite two desserts.
Of course, you could invest in both mutual funds and index funds — just like you could order both desserts — but regardless, there are some differences between both types of funds that can help you make an informed investment decision.
Let's go over the differences between mutual funds and index funds as you consider which is better for your personal portfolio and financial situation.
Mutual funds
So, how does a mutual fund work? A mutual fund pools money from multiple investors and invests it into different securities. Think of the individual securities that make up a mutual fund as the ingredients for baking cookies — chocolate chips, baking soda, flour, butter, eggs.
Buying shares of a mutual fund means you purchase all the ingredients in the mixing bowl. In investing, it's often referred to as buying into a basket of securities — in other words, you become a shareholder of that mutual fund.
Mutual fund security types can include individual stocks, bonds, real estate or commodities (such as gold, beef, oil). Unlike purchasing individual stocks, in which you make all the investment decisions, a fund manager decides which securities go in the fund and how to buy and sell individual securities. In other words, it's not up to you to build these decisions into your investing.
Some ways through which you might earn money from mutual funds are:
Dividends: Individual securities pay dividends to investors, which means that a distribution of profits by a corporation goes toward shareholders.
Capital gains: Through mutual funds, you can also take advantage of capital gains. Capital gains are the profits earned from selling a security for more than it was purchased for. This can occur if you sell your shares of a mutual fund for more than what you initially paid.
Index funds
An index fund is a type of mutual fund or exchange-traded fund (ETF). An index fund, also called an index mutual fund, is a bundle of stocks that mirrors the performance of an index, like the S&P 500, the Dow Jones Industrial Average (DJIA), the Nasdaq Composite or the Russell 2000 Index. Because index funds follows a specific index, they’re considered passively managed, and they also carry lower fees than actively managed funds.
Index funds can reduce short-term capital gains because index funds eliminate the constant buying and selling by active fund managers. However, active fund managers have the flexibility of choosing securities that give consumers the lowest tax bite.
Index funds can contain many, many underlying securities, which makes them more diversified and less volatile than individual stocks. By their very nature, index funds seek returns that match an index and can produce fairly predictable results over time.
Index funds generally don't pay capital gains to an investor until you sell the fund because they make few stock trades due to merely tracking an index. Index funds can, however, pay out dividends.
Differences between mutual funds and index funds
What is the difference between a mutual fund and an index fund? Let's take a look:
| Mutual fund | Index fund |
|---|---|---|
Investment objective | Aims to beat the returns of a benchmark index | Returns are based on a benchmark index, such as the S&P 500 |
Types of investments | Stocks, bonds, other securities | Stocks, bonds, other securities |
Management style | Fund managers pick the securities | Passive management style — they follow the index |
Fees | Typically cost more than index funds because you're paying a middleman — the fund manager | Typically cost less than mutual funds |
Which is better, index funds or mutual funds?
As with any investment, it depends heavily on what you want. Do you prefer active management to passive management? Do you want to pay fewer fees or more fees? Let's go over the pros and cons for you to consider.
The pros and cons of a mutual fund
First, the pros of mutual funds. They offer:
Investment diversification
The opportunity to invest in many different types of securities
Access to others who manage your money, resulting in simplified investment decisions
Liquidity — you can access them anytime you want
On the other hand, cons of mutual funds include:
Generally higher cost compared to some other funds due to high expense ratios and other sales charges
Less control over your portfolio because the mutual fund manager makes decisions on your behalf
No intraday trading — they trade only once per day, after the financial markets close
The pros and cons of an index fund
Next, let's take a look at the pros and cons of an index fund.
Pros:
Is a lower cost investment due to passive investing
Offers diversification
Tracks the returns of market indexes, which may be more reliable
Cons:
No control over holdings — you don’t choose what goes into the fund (like you would if you would choose individual stocks)
Moves in reaction to the stock market, which means if the stock market goes down, it goes down
I want to invest in the S&P 500. How do I do that?
The S&P 500 is not an active mutual fund or an index fund. It is a stock index that tracks the performance of 500 of the largest companies listed on stock exchanges, which refers to market capitalization of more than $10 billion. In order to invest in the S&P 500, you must invest in a fund that tracks it.
Making your mutual fund vs. index fund decision
Which type of fund will work best for you and your specific investment needs? Actively managed funds or passive options? Do you have a specific index you want to track with your investment?
Before making an investment decision, consider your entire financial situation and what your objectives are with your investments. Once you have a full picture and better understanding of the differences between mutual funds and index funds, you’ll be better equipped to come to a conclusion that’s best for your portfolio.
