Both index funds vs mutual funds are some of the best options to consider if you are willing to improve your portfolio without hand-picking individual stocks. They both allow you to diversify your investments across multiple industries and assets while reducing risk levels.
While both the investing options may seem pretty similar, investors need to understand that there are differences between them, and they must not use the other option synonymously.
In this article, we shall have an in-depth discussion on all the differences between index funds vs mutual funds so that you can make a calculated decision before investing your hard-earned money.
Index Funds Vs Mutual Funds: Definition
Here is a brief definition of each of the funds. This will paint a clearer picture before we get ahead with the differentiations.
In simple terms, mutual funds are very meticulously managed investment pathways that collect funds from multiple investors. When an individual gets hold of a share of a mutual fund, they are necessarily obtaining a part of ownership in the fund. This entitles them to a proportion of the income or capital gains the fund generates.
The dedicated investment manager is in charge of deploying the fund’s assets across a wide array of assets, including bonds, stocks, and other securities. These professionals make vital decisions regarding the correct choice to make while purchasing, selling, or trading assets on behalf of the shareholders of the fund while optimizing the returns and managing the risks efficiently within the investment landscape.
The index fund, on the other hand, is not a very distinctive investment pathway but is more a type of passively managed mutual fund that is designed to keep a close track of the performances of specific market indices. Index funds in the biggest of economies operate by replicating the holding of the weightings of the securities within a chosen index and looking forward to benchmarking the performance of the index as closely as possible.
These funds can include all of the holdings in an index or just a representative sample of them. The core objective of index funds is to replicate the movements and returns of the underlying index. Index funds are quite preferable among many investors, primarily those who have a long-term, passive investment strategy, because of their low prices and consistent tracking of performance of market thresholds.
Top Differences Between Best Index Funds Vs Mutual Funds
Now that you have a brief idea of what each of these funds are individually, let us go through the key differences that set these two funds apart.
Investing And Management Style
The key difference between index funds vs mutual funds is the allocation and management of the funds. Mutual funds that are actively managed need fund managers to confirm the asset combination and the investment proportion. Therefore, the fate of these funds will depend highly on the fund manager’s experience, skill set, and bias.
Contrary to this, index funds require passive management. These funds keep track of famous benchmarks like S&P 500, or Nasdaq-100, and invest in the same units and identical proportions. This way, the funds may take their underlying standards as a wireframe for the investment and replicate its properties. Hence, index funds offer more of a hands-off investment approach.
This certainly is one of the most prominent differences between index funds vs mutual funds. You may consider it from an investor’s perspective, and it lies within their operating costs.
The annual price for managing these operations is known as the expense ratio. This value is expressed as a percentage of the assets under management of a scheme.
As I mentioned above, fund managers constantly perform extensive industry research with actively managed mutual funds. Thereafter, they may choose the securities that help in mobilizing the available assets. This is the reason why the expenses of these funds are adequately high.
However, because index funds are managed passively, they require little to no involvement from the fund manager. As a result, the expense ratio for these funds is quite affordable. However, these charges may vary around different fund houses.
The index funds vs mutual funds performance is a contrasting factor that helps in differentiating between both the funds.
Mutual funds have the tendency to outperform the current benchmarks set within the market. This is a goal that is based on the fund manager’s mix-and-match holdings.
On the other hand, index funds have a record of outperforming mutual funds over 80% of the time. This happens because the former keeps trying to emulate higher-performing benchmarks. They try to mirror the performance of their underlying index rather than beating it. When the market conditions tilt towards bearish, there is very little chance of index funds providing poor returns as compared to active funds.
This is the reason why most investors prefer maintaining a combination of active and passive mutual funds. This way, a better return from one can easily compensate for the loss that investors incur from the other.
An investor has to conduct extensive research before they choose an active fund. Before deciding to invest, they must consider past returns, total AUM, fund managers’ historical returns, etc.
On the other hand, index funds that can keep track of the same index may usually have the same returns. They are simple to understand, and the decision usually comes down to the tracking error and expense ratio.
There is no mutual fund investment that comes with zero risks. The index fund is also a sub-category of mutual funds; therefore, market volatility plays an important factor here. One of the factors that you may notice in both funds is the type of risks involved.
When speaking about mutual funds, the risk mainly depends on the market capitalization of the holdings, while the risks involved with index funds are mainly based on their underlying index.
The Bottom Line
If you are still confused about index funds vs mutual funds, you must make the choice based on your financial goals and where you stand financially at present. While index funds have a long history of outperforming mutual funds, there are also highly active and efficient fund managers.
However, if you are someone who has just started exploring mutual funds, it is always better to consider investing in index funds before you choose active mutual funds.