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Index Funds vs Mutual Funds: The Differences That Matter

what is the difference between mutual fund and index fund

While both vehicles play critical roles in portfolios, they operate quite differently. Generally, mutual funds and index funds have relatively low fees, but index funds tend to have lower expense ratios than mutual funds. Index funds also tend be more tax efficient, but there are some mutual fund managers that add tax management into the equation, and that can sometimes even things out a bit.

When examining your investment choices, it’s important to keep in mind that while some investment experts occasionally achieve superior results, their performance tends to be inconsistent. S&P Dow Jones Indices’ scorecard, which evaluates the performance of actively-managed mutual funds against major indices, provides valuable insights. Over a one-year period, it revealed that 51.08% of actively-managed mutual funds in India underperformed the S&P 500, while 48.92% outperformed it. These statistics, however, undergo significant changes over longer time frames. The reason behind the lower costs of index funds lies in their passive management strategy. These funds do not require intensive decision-making by fund managers to select individual securities for buying and selling.

what is the difference between mutual fund and index fund

For those who own shares of mutual funds, retirement is the most common goal. Mutual funds are a good fit for retirement savings because they provide broad diversification. Other common goals for mutual fund investors include saving for emergencies or a child’s college education. One difference between index and regular mutual funds is management. Regular mutual funds are actively managed, but there is no need for human oversight on buying and selling within an index fund, whose holdings automatically track an index such as the S&P 500.

Is An Index Fund Or A Mutual Fund Better?

Investors can buy shares in a single entity, the fund, to get exposure to the hundreds of securities that the fund invests in. Mutual funds are trying to pick a mix of stocks that will beat the average returns of the stock market or a particular benchmark index. In most cases, buying an ETF is easier than buying a mutual fund or index fund. That’s because ETFs are bought on an open exchange, whereas mutual funds and index funds are priced at the end of the day. You can usually buy ETFs in smaller amounts and buying them doesn’t require a special account. Exchange-traded funds, or ETFs, mutual funds and index funds are all common investment products.

Or perhaps you have a more specific goal like tracking the index of a certain sector such as financial stocks. Index funds could also be part of a factor investing strategy where you seek exposure to something like small-cap value stocks. Importantly, the goal isn’t to outperform the benchmark index its holdings are based on. When the manager actively selects which stocks to buy (and which ones not to), it’s called an actively managed mutual fund. That stands in contrast to passively managed funds or index funds.

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. 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.

Investing in a mutual fund is not trading shares of specific companies held by the mutual fund; it is trading shares of the mutual fund company itself. Investors buy and sell their stakes in mutual funds at a price set at the end of a trading session; their value does not fluctuate throughout the trading session. ETFs, mutual funds and index funds each give you access to hundreds of stocks and bonds in a single product.

what is the difference between mutual fund and index fund

The terms ETFs and index funds are sometimes used interchangeably, but they can mean different things. Both adopt a passive investing strategy and have lower fees compared to actively managed mutual funds. They both track a specific index or sector, such as the S&P 500 or oil and gas. And, like mutual funds, index funds are priced at the end of the day. An index fund, much like a mutual fund, will pool investors’ capital and buy a portfolio of securities.

The objective of the fund will dictate how the portfolio is managed and what investments are included. However, index funds have fees as well, though the lower cost of running such a security usually results in lower fees. Remember, the lower the management fees, the more the shareholder can receive in returns. Most mutual funds, which often carry minimum balance requirements, fall into one of four categories.

Mutual funds

You can work with a financial advisor or investment professional to help you identify and choose which funds to include in your Roth IRA and 401(k). Mutual funds have active management, meaning they have a team of financial experts looking for the right stocks to include in their fund. In the investing world, index funds are the very definition of the “average” investment. But if you could find an investment with better than average returns, wouldn’t that be something worth shouting from the rooftops? According to ICI, 48% of households with mutual funds owned equity index funds, or index funds that invest primarily in stocks. Mutual funds and index funds are popular options for diversifying your portfolio without having to hand pick individual stocks.

  1. Expense ratios for actively managed mutual funds can be 10 times higher than comparable index funds.
  2. And if you’re wondering whether it’s worth getting help from a financial advisor or investment professional, here are some things to keep in mind.
  3. The fee could be paid up front (front-end load) or when the shares are redeemed (back-end load).
  4. With index funds, the goal is to simply mirror the performance of an index, while with a mutual fund, the objective is to outperform the market.

An index fund – whether structured as a mutual fund or ETF – takes a more passive approach. There is no fund manager actively managing an index fund since the fund is tracking the performance of an index. Index funds aim to buy and hold the securities that coincide with the indexes they track. Therefore, there is no need to buy and sell securities regularly. This is one of the biggest differentiators of index funds vs. mutual funds. Index funds cost money to run, too — but a lot less when you take those full-time Wall Street salaries out of the equation.

Investing Strategy

ETFs are attractive to many people since their MERs  are often significantly lower than those of mutual funds. The drawbacks of an ETF include that you may have to pay a commission to your broker to buy shares. That said, many brokers have gotten rid of commissions on simple purchases like ETFs. More brokerage services are also supporting fractional investing.

A mutual fund company collects inflows and outflows of investors’ money throughout the day. 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. Investing involves risk, including the possible loss of principal. While the difference at first seems slight, over the long term, the impact can be significant.

Start investing in Canada by reviewing your finances, exploring your account options and learning how to compare brokerages. Volatility profiles based on trailing-three-year calculations of the standard deviation of service investment returns. He has more than a decade’s experience working with media and publishing companies to help them build expert-led content and establish editorial teams. At Forbes Advisor, he is determined to help readers declutter complex financial jargons and do his bit for India’s financial literacy. Ramsey Solutions is a paid, non-client promoter of participating Pros. It’s just a measuring stick for the stock market or a sector of the stock market.