Investors who want to buy into a fund rather than an individual stock or other type of asset may be drawn to index funds and mutual funds. Both options can help spread out investors’ money, allowing them to diversify their investment portfolio. In fact, some mutual funds are index funds. But there can be one big difference: While index funds closely track the ups and downs of an index, some mutual funds are actively managed funds designed to outperform an index.
What is an index fund?
An index fund is a type of investment that tries to replicate the ups and downs of an underlying benchmark index.
For example, the Standard & Poor’s 500 Index or the S&P 500, is a commonly used benchmark index that tracks 500 of the largest publicly traded companies in the US. It’s considered a representation of how the stock market is doing overall. An index fund that tracks the S&P 500 index allows investors to access market returns by buying a single share of a fund, rather than buying individual shares of all 500 companies.
Index funds can be based on any market index. The S&P 500 index is a broad index because it tracks a large portion of US stocks; but there are even broader options, such as the Russell 2,000 Index, or global indexes. There are narrowly focused options as well, such as an index that tracks a specific state’s municipal bonds or companies from a specific industry.
Index funds can be either exchange-traded funds (ETFs) or mutual funds. However, says John DeYonker, head of investor relations at Titan, “more times than not, when you're talking about an index fund, you’re talking about an ETF.”
What are mutual funds?
An index fund is a type of investment that tries to replicate the ups and downs of an underlying benchmark index.
For example, the Standard & Poor’s 500 Index or the S&P 500, is a commonly used benchmark index that tracks 500 of the largest publicly traded companies in the US. It’s considered a representation of how the stock market is doing overall. An index fund that tracks the S&P 500 index allows investors to access market returns by buying a single share of a fund, rather than buying individual shares of all 500 companies.
Index funds can be based on any market index. The S&P 500 index is a broad index because it tracks a large portion of US stocks; but there are even broader options, such as the Russell 2,000 Index, or global indexes. There are narrowly focused options as well, such as an index that tracks a specific state’s municipal bonds or companies from a specific industry.
Index funds can be either exchange-traded funds (ETFs) or mutual funds. However, says John DeYonker, head of investor relations at Titan, “more times than not, when you're talking about an index fund, you’re talking about an ETF.”
What are mutual funds?
Mutual fund companies create and manage mutual funds by pooling investors’ money to purchase stocks, bonds, and other assets. The company manages the fund on investors’ behalf and may pass on dividends or other earnings to the fund holders.
Mutual funds can take one of two approaches: passively managed or actively managed. “There are mutual funds that look very similar to ETFs and that track the S&P 500,” says DeYonker. These passively managed mutual funds are a form of index fund, as they are set up to track their benchmark without a lot of hands-on work from the fund managers.
However, DeYonker says mutual funds are often actively managed. This means that the fund managers use different types of analysis to pick specific investments, with the goal of beating their benchmark. They may also time the purchase or sale of assets and derivatives based on their investing strategy, research, and market predictions.
How to compare index funds vs. mutual funds
Because some mutual funds are passively managed index funds while others are actively managed, investors may want to review the fund’s goals and management style to make sure they know what they’re buying.
Similarities
Index ETFs, index mutual funds, and actively managed mutual funds can all have:
- Diversification. Investors can purchase index or actively managed funds to diversify their portfolio.
- A variety of options. Investors can also choose from many passive or active funds based on their individual goals, risk tolerance, and investment time horizon.
Key differences
Investors may also consider the differences between passive and active funds, particularly when comparing index ETFs to actively managed mutual funds.
- How the fund is traded. An ETF will be listed and traded on a stock exchange, and investors can buy or sell shares when the market is open. At most, mutual funds are traded once per day when the market closes.
- Initial investment requirements. “A lot of mutual funds still have minimum investments, $2,500 or $3,000 minimum,” says DeYonker. With an index ETF, investors only need enough money to purchase a single share. In some cases, investors can buy fractional shares of ETFs.
- Expense ratios. Most funds come with a fee that covers operational expenses. “But actively managed mutual funds generally have higher expense ratios than ETFs,” says DeYonker.
- Mutual fund fees. Mutual funds may charge investors load fees (i.e., 12b-1 fees) in addition to their expense ratios.
- Tax implications. Investors who aren’t investing in a tax-advantaged account can consider the tax implications for holding either type of fund. ETFs tend to be more tax-efficient than mutual funds (index or active) because they don’t buy and sell the underlying assets as often.
The bottom line
Some mutual funds are also index funds, but more often, mutual fund managers actively manage the fund to try to outperform an index. In exchange, investors may pay higher fees to compensate the fund managers. Investors can review each mutual fund’s requirements, fees, and investment objectives to make sure it fits their portfolio. They also assess the difference and similarities between index funds versus mutual funds versus ETFs.
