As an investor, you have multiple investment vehicles to choose from – including mutual funds and index funds. While they have similarities, these funds have different management styles and cost factors that you should consider before you invest.
The good news is, there are numerous options that you can choose from, all of which can help you diversify your portfolio and reach your goals.
What Is an Index Fund?
Index funds are an investment vehicle that complies multiple companies within it to mirror and track key benchmark indexes, like the S&P 500. They are designed as passive funds that track the index, with a composition of stocks, bonds, and other securities within them.
If you were to invest in an index fund that tracked following the S&P 500 index, you would likely have investments in the following companies: Facebook (FB), Ford Motor Company (F), CVS Corp. (CVS), Goldman Sachs (GS), and the like. Typically, but not always, your index fund will rise and fall at the same percentage as the index it is set to follow.
What Is a Mutual Fund?
A mutual fund pools money from multiple investors and places it in securities like stocks, bonds, and other short-term debts. They are well diversified, and many come with different goals – like long-term growth or fixed-income. Because they are actively managed by a fund manager you pay a fee, typically one that is higher than those of an index fund.
Mutual funds try to outperform the market. Instead of holding shares of specific companies, if you invest in a mutual fund, you are trading shares of the mutual fund itself. For example, if you are looking to invest in a large value fund, the most popular option is the Vanguard Windsor II Fund (VWNFX).
Its broad range of investments within the portfolio provide long-term capital appreciation. Other great mutual fund options include Fidelity Select Health Care Services Portfolio (FSHCX), Trans-America Large Cap Value I2 (TWQZX), and AQR Style Premia Alternative R6 (QSPRX).
How Are Index and Mutual Funds Similar?
Index funds and mutual funds both invest in stocks, bonds, and other securities. They also both help diversify your portfolio and provide returns over extended periods of time. However, they tend to have more differences than similarities.
What Are the Key Differences?
There are many differences between index funds and mutual funds. From initial investment to management style, the two fund types have numerous differences.
Typically, an index fund requires investors to place $3,000-$10,000 of capital for their initial investment. Alternatively, mutual funds require a minimum initial investment somewhere between $500-$5,000.
The investment goals for mutual funds and index funds could not be further apart. An index fund’s objective is to match the index before fees. A mutual fund’s objective is to beat the returns of an index.
Another night and day difference between index funds and mutual funds is how they are managed. Index funds are passive investments, meaning they are not constantly trading and adding investments. Mutual funds, with the objective to beat the index, are actively managed, meaning they have fund managers that continually pick securities to buy or sell.
Both index funds and mutual funds have fees that you should consider. On average, the fees for index funds are lower than mutual funds due to their passive investing strategy.
The average fee for an index fund is around .09%. The average fee for a mutual fund is around .82%.
Example of Index and Mutual Fund
Let’s take a look at two real-life examples of an index fund and a mutual fund. Starting with an Index Fund, we’ll look at Schwab S&P 500 Index Fund (SWPPX). This index fund tracks the S&P 500 index. There is only a 0.02% management fee on this index fund, meaning that every $10,000 you invest would cost $2 annually. The 5-year average return of the fund is 11.39%.
Now, we’ll take a look at a mutual fund – the Fidelity Contrafund (FCNTX). This mutual fund has a management fee of 0.86%. This means that for every $10,000 you invest, you would pay $86 annually. The 5-year average return on this fund is 19.14%.
Mutual Fund Advantages & Disadvantages
Even though mutual funds are a popular investment option, you should familiarize yourself with the advantages and disadvantages before you invest.
There are many things that make mutual funds advantageous to investors, including:
- Dividend Reinvestment
- Risk Reduction
- Advanced Portfolio Management
- Convenience and ease of understanding
With all the benefits of mutual funds, there are of course some downfalls including:
- High expenses and hidden fees
- Poor trade execution
- Tax inefficiency
Index Fund Advantages & Disadvantages
Depending upon your investment goals, you might find that an index fund is better suited to add to your portfolio. Before you make your decision, explore index funds advantages and disadvantages.
For a passive investment vehicle, index funds are filled with multiple advantages including:
- Low risk and steady growth
- Lower fees
- Tax Advantages
- Broad diversification
If this passive investment option is what you are looking for, be sure to understand the disadvantages before investing.
- Lack of flexibility
- No large gains
- Possibility of under-performance
How To Invest in Mutual and Index Funds
If you have weighed the pros and cons of index funds and mutual funds and are ready to invest, there are a few ways you can do so. The first place you should look is your 401(k). When you set up your retirement account, you likely were able to select from a list of mutual funds. Your employer can provide you with detailed information to adjust your selections if that suits your needs.
To go a step further, or if you do not have a 401(k), you can open an IRA through your bank, brokerage firm, or other financial institution. You will then have options of funds to invest in.
Finally, you can invest in non-retirement accounts through a brokerage account. Your financial advisor or brokerage firm can help you see what funds are available and provide you with tools to compare each option.
Picking the Right Fund
Index funds and mutual funds are both great ways to diversify as an investor. If you are unsure of where to begin, reach out to your financial advisor to help you make smart investment choices. After all, certain investments are not for everyone.
You will want to check to make sure you invest in a fund that aligns with your goals and your risk management; your financial advisor can help.