One of the first questions for beginning investors centers around what investment options you should choose for your portfolio. For many, the prospect of spending time researching dozens of individual stocks and other asset classes isn't the most appealing. This is why both index funds and mutual funds have become a mainstay for nearly 70 million investors.
But what is the difference between index funds and mutual funds, and when would it make sense to invest in one over the other?
Index funds vs. mutual funds
An index fund is a type of mutual fund that invests exclusively in companies listed on the index it is named after, such as the S&P 500.
Mutual funds, on the other hand, are companies that invest in stocks, bonds, and other assets chosen by a fund manager and may change their holdings based on how the market is performing (these are often referred to as actively managed funds).
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To understand each of the differences in detail, let's dive deeper into each investment's benefits and drawbacks.
What is an index fund?
An index fund is an investment vehicle that’s designed to match the performance of a particular index. This means that when the index increases or decreases, the value of the fund will mirror those gains and losses.
The first index fund was the Vanguard First Index Investment Trust started by John Bogle in 1976. Since the creation of index funds in the 1970s, they have exploded in popularity with investors, totalling more than $7 trillion invested worldwide.
Index funds have become an important investing tool because they can offer instant diversification with low expense ratios, and less risk than owning individual stocks.
How index funds work
When you buy into an index fund, your money is invested in all of the stocks included in that index and the performance of the fund will closely follow that of the chosen index. The S&P 500 is one of the most popular indexes that tracks the largest 500 companies in the United States although it’s certainly not the only one out there. The Nasdaq 100 tracks the largest non-financial companies listed on the Nasdaq stock exchange. The Russell 2000 is an index that tracks small cap stocks. There are also index funds that track other markets such as the Barclays Aggregate US Bond Index.
Pros and cons of investing in index funds
Index funds have become more popular in the last two decades because of their simplicity and the increased use of robo-advisors. But like any investment, there are pros and cons that you should consider in your investing decision.
Pros
- Lower fees on average compared to actively managed mutual funds
- Requires very little expertise to invest
- Offers an easy way diversify a portfolio
Cons
- No control which stocks are added or taken out of the index
- No protection if the market falls
- Generally cannot beat the stock market, it can only mirror it
Index funds are often lauded as the must-have choice to build your portfolio around. Even legendary investor Warren Buffett has suggested that his multi-billion dollar fortune be allocated to index funds when he passes. This does not mean that you should approach index funds as a set-it-and-forget-it solution. "There's no active risk management happening. So, while index funds are helpful tools for investors, you need to consider the risks in your own life and plan accordingly," says Evon Mendrin, certified financial planner and lead advisor at Optometry Wealth Advisors.
What is a mutual fund?
A mutual fund pools money from many investors to purchase a portfolio of stocks, bonds, or other investments. The selection of these investments are decided by a team of fund managers. Investors who buy shares of the mutual fund will participate in the fund's gains and losses based on the fund's holdings. Similar to index funds, mutual funds reduce risk for individual investors since there can be money spread across multiple assets instead of choosing just one.
How mutual funds work
Mutual funds work by first establishing one or more objectives, which are explained in the fund's prospectus. The prospectus also provides information about the risks, fees, management, performance history, portfolio holdings, and more. The fund manager's role is to buy (or sell) investments to meet the objective of the fund. For example, the American Funds’ Investment Company of America objective is, "to achieve long-term growth of capital and income." Having the guidance of money managers comes at a cost. “Often mutual funds tend to be higher in cost because humans are being compensated for their potential knowledge, skill, experience, and foresight,” says Chris Kampitsis, certified financial planner and financial planner at the Barnum Financial Group.
Pros and cons of investing in mutual funds
The first mutual fund was created nearly one hundred years ago and with such a long history, mutual funds have provided investors with the potential for diversification, growth, and a level of capital preservation. These benefits should be carefully weighed against the drawbacks of mutual funds to determine where they could fit in your portfolio.
Pros
- Guidance of professional investors
- Potential to outperform index funds
- Provides diversification across multiple assets
- Mutual funds managers may adjust holdings to preserve capital in a down market
Cons
- Higher expense ratios compared to index funds
- No control over management team
- Most actively managed mutual funds underperform compared to index funds after fees
How to choose between the two
As with most financial decisions, your choice will come down to your financial goals. If you’re looking for passive, low-cost diversification, then an index fund may be a good fit. Additionally index funds tend to outperform actively managed funds. The Wharton School at the University of Pennsylvania found that 97% of fund managers for large- and mid-sized companies produced lower returns compared to their index counterparts. When could mutual funds be a good choice? "It depends on the investing philosophy of the investor,” says Mendrin. "Those that feel they are better off with a more active management approach based on the skill of the manager are willing to pay the (typically) higher cost and hope for outperformance or better risk management," he adds.
