Index Funds vs. Mutual Funds

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Contributor, Benzinga
October 16, 2023

Index and mutual funds both pool investments to offer diversification, and understanding the characteristics of each may be challenging. This comparison of index funds versus mutual funds pits the two popular investment choices against each other, examining their performance, fees, risks and tax efficiency.

What Are Index Funds?

Index funds aim to passively replicate a market index’s performance, such as the S&P 500 or NASDAQ, by investing in a collection of stocks, bonds or other assets representing a specific market segment. An example is the S&P 500 index, which consists of 500 large U.S. companies that cover about 80% of available market value. Index funds generally buy and hold the same securities as the index they track in the same proportion. This passive feature means they do not need to actively manage their portfolio, unlike active mutual funds that try to beat the stock market by picking and choosing individual securities.

Pros

  • Lower expense ratios than many types of funds
  • Diversified investing across different securities in one fund
  • Passive and straightforward investment strategy that follows the market
  • Historically speaking, relatively consistent returns over the long term

Cons

  • Limited potential for outperformance compared to actively managed funds
  • Exposure to market fluctuations and downturns
  • Tracking error risk, or the difference between the fund’s performance and the index’s performance because of fees, rebalancing or other factors
  • Lack of customization and flexibility for investors seeking to invest more heavily in certain areas or stocks 

What Are Mutual Funds?

Mutual funds are investment vehicles that pool money from numerous investors to invest in various securities, including stocks, bonds or commodities. They are managed by professional fund managers who decide how to allocate the fund’s assets based on the fund’s objectives and strategies. Mutual funds can be created with investments in different products like equity, fixed income and more, and the strategy can vary widely. Many mutual funds are actively managed, though the number of passive mutual funds that track an index is also growing. 

Pros

  • Professional management and expertise by fund managers and advisers
  • Potential for active management strategies that may generate higher returns than passive strategies
  • Customization and flexibility for investors who want to invest in specific asset classes, sectors, themes or goals

Cons

  • Higher expense ratios than index funds because of active management and research costs
  • Possible inconsistency and unpredictability of returns because of active investment choices
  • Risk of investments managed by a fund manager that may underperform the market
  • Higher capital gains taxes because of frequent buying and selling of securities

Comparing Index Funds and Mutual Funds

Both index funds and mutual funds pool funds from several investors to invest in a basket of securities. Still, they differ in several aspects.

Performance Comparison

Research shows index funds tend to outperform actively managed mutual funds over the long term because of their lower costs, higher diversification and lower turnover. According to Investment Company Institute (ICI), the average expense ratio for index funds in 2021 was 0.06%, compared to 0.68% for actively managed mutual funds. This difference means index fund investors can save more on fees and keep more returns. 

Index funds usually offer more diversification because they hold all or most of the securities in a given market segment, reducing the risk of losing money because of the underperformance of a single company or sector. They also have lower turnover rates, which means less trading costs, fewer capital gains distributions and potentially lower taxes. 

Actively managed mutual funds can still achieve superior returns over time, especially when portfolio managers have exceptional skills or under market conditions conducive to active management.

Costs and Fees

Expense ratios are charged annually as a percentage of the total assets and cover the fund’s operating costs. Index funds generally have lower expense ratios than mutual funds, making them a more cost-effective investment option. When brokers or financial advisers buy or sell securities on behalf of investors, they charge commission fees, which can increase transaction costs. 

Mutual funds may charge load fees or sales charges when investors buy or sell shares of the fund. Load fees can be front-end or back-end. Funds may also charge management or service fees. Index funds generally have lower or no commission fees, load fees, redemption fees or account fees compared to mutual funds. 

Risk and Diversification

Both index and mutual funds offer diversification for investors looking to reduce risk and increase returns. Diversification involves investing in diverse securities across sectors, industries, regions and asset classes to reduce the impact of poor performance or losses in any area.

Index funds provide diversification by holding all or most of the securities in a given market segment, such as the S&P 500 or Nasdaq-100. Mutual funds also offer diversification based on their objectives and strategies, such as investing in stocks from different sectors or bonds from different issuers.

Index and mutual funds may carry risks, such as:

  • Tracking error: Index funds are subject to tracking error — the difference between the fund’s return and that of its benchmark index. A lower tracking error indicates a better ability for the fund to mimic the index, while a higher tracking error suggests the opposite. Fees, rebalancing, sampling and replication methods can cause this error.
  • Poor fund management: Mutual funds can be at risk because of bad fund management, resulting from a lack of skill, experience, knowledge, discipline or ethics. Poor fund management occurs when a fund manager makes bad decisions or mistakes that lead to underperformance or losses for the fund.
  • Lack of flexibility: Index funds track a specified index and do not adjust in response to changing market conditions, opportunities or risks. Actively managed mutual funds may recalibrate portfolios more often, though they do not change their investing strategy or style.

Investment Objectives and Flexibility

Investors have specific goals when investing, such as generating income, achieving growth or preserving capital. Flexibility helps investment funds adapt to various market segments, asset classes and investment objectives.

Index funds can track any existing or newly created market index, including broad-based, sectoral, regional, thematic and factor indexes. They can also follow different asset classes, such as stocks, bonds, commodities and real estate, for investors to achieve varying investment objectives like income, growth and diversification. But the fund portfolio is not very flexible because it is trying to mimic an index.

Mutual funds can be relatively more flexible so that managers can customize their portfolios based on investment goals. They can invest in any type of security allowed by their prospectus and regulations, including stocks, bonds and currencies. Investors often try to satisfy financial objectives like income and capital appreciation.

Both index and mutual funds also have some limitations regarding their investment objectives and flexibility. 

  • Lack of control: Index and mutual fund investors have limited control as they cannot influence the decisions or actions of fund managers or index providers. Investors cannot choose which securities to buy or sell, determine when these decisions should be made, allocate amounts or participate in corporate actions or governance matters.
  • Lack of customization: Index fund investors cannot customize their portfolios to their preferences or needs. Lack of customization means they cannot exclude particular securities or segments they don’t like or adjust their portfolios based on their risk tolerance, time horizon, tax situation or other factors. 

Tax Efficiency

Factors that affect tax efficiency include the type of fund, the type of account, the type of income, the holding period and the tax rate. Index funds tend to be more tax-efficient than mutual funds because of their low turnover and capital gains distributions. High turnover can result in more trading costs and capital gains distributions taxed at the investor’s income tax rate. Mutual funds, on the other hand, tend to have lower tax efficiency because of their high turnover and capital gains distributions. 

Both funds can have different tax implications depending on the type of account investors use to hold them. In a tax-advantaged account, like an individual retirement account (IRA) or 401(k), investors can defer paying taxes until they withdraw their money from the account. Investors must pay taxes on their income and capital gains every year in a taxable account, such as a brokerage or bank account.

Best Investment Brokerages

Whether you’re investing in index or mutual funds, you need a reputable investment brokerage to get started. To help you compare and choose the best broker or platform for your needs, Benzinga reviews the most popular and reputable brokers and platforms offering index funds and mutual funds.

Index Funds vs. Mutual Funds: Solving the Dilemma

Choosing between index and mutual funds depends on your investment goals, preferences and risk tolerance. Index funds generally offer lower expenses, tax efficiency and consistent performance tied to market indices. On the other hand, mutual funds provide professional management and flexibility but may come with higher costs and the potential for inconsistent returns. 

Frequently Asked Questions 

Q

Are index funds and mutual funds the same?

A

No, they differ in their investment approach, with index funds usually tracking market indices passively while professionals often actively manage mutual funds.

Q

Are index funds safer than mutual funds?

A

Index funds may offer more stability from diversification and lower fees, while actively managed mutual funds may carry more risk. No investment is guaranteed.

Q

Is the S&P 500 an index fund?

A

No, the S&P 500 is a market index that some index funds track to replicate its performance.