Two of the most popular investment vehicles are mutual funds and index funds. Both provide low fees and the potential for higher returns than individual stocks or bonds alone.
Below, we will explore the differences between index funds vs. mutual funds in terms of features, costs, diversification, and more, so that you can make an informed decision about which type of fund best meets your investment goals.
What are mutual funds?
Mutual funds are investment vehicles that pool money from multiple investors and use it to invest in a range of securities such as stocks, bonds, commodities, or money market instruments.
They are professionally managed and provide diversification benefits, potentially helping investors to achieve higher returns than investing in individual stocks and bonds on their own.
According to the Investment Company Institute (ICI), a little over 50% of US households own mutual funds as of 2022. This figure is up from 39% in 2010.
It is difficult to predict how many US households will own mutual funds in 2023, as the rate of ownership is dependent on factors such as the performance of the market, investor confidence, and changes in consumer behavior. However, it is likely that the percentage of households owning mutual funds will continue to rise as investors become more aware of the potential benefits of mutual fund investments.
Mutual funds are best suited for investors who want to diversify their portfolios and potentially earn higher returns than investing in individual stocks and bonds alone for example people looking forward to retirement. Mutual funds can also be a good option for those with limited capital, as the investment costs are lower than investing in individual stocks or bonds.
When you buy a mutual fund, you are now a part owner and are therefore entitled to a proportional share of the capital gains from your investment. Your money is pooled together with other investors and used to purchase a range of investments such as stocks, bonds, or money market instruments.
The fund manager then makes decisions on behalf of the fund’s shareholders on when to buy and sell investments in order to maximize returns.
Active vs. passive management of mutual funds
Passive management involves tracking a specific market index (such as the S&P 500) and replicating its performance. With passive management, the fund is not actively managed and there are no decisions made about when to buy or sell investments.
Active management, on the other hand, involves making decisions about when to buy or sell investments in order to maximize returns.
Mutual funds are typically actively managed by professional fund managers, while index funds are passively managed.
What are index funds?
Index funds are investment funds that follow a particular index, such as the S&P 500, and track its performance. They aren’t different from mutual funds. They are in fact one of the types of mutual funds.
They are designed to offer investors low fees, diversification, and potentially higher returns than actively managed funds.
Index funds get their name from the fact that they track a specific market index and mirror its performance. The most common index that is tracked by index funds is the S&P 500. However, other indices, such as the Dow Jones Industrial Average (DJIA) or the National Association of Securities Dealers Automated Quotations (NASDAQ), can also be tracked.
According to the Investment Company Institute, just over 20% of US households own index funds as of 2022. This figure has grown from 11% in 2010.
Index funds vs. mutual funds
Both provide fixed-income and portfolio diversification however there are some differences between the two.
There are five main differences between index funds and mutual funds.
- Management
- Index funds are passively managed, meaning that they track a specific market index and imitate its performance without any active management. Mutual funds, on the other hand, are actively managed by professional fund managers who can make decisions about when to buy or sell investments in order to maximize returns.
2. Costs
- Index funds typically have lower fees than mutual funds due to their passive nature. This means that the return on the funds will be higher as the investor won’t have to pay a portion of their returns to the fund manager.
- The average management fee (expense ratio) of mutual funds is usually higher than that of index funds, typically ranging from 0.5% to 2%. Index funds typically have lower fees, ranging from 0.09% to 0.2%. *Figures from the ICI. For more about the average management fee and expenses associated with mutual funds and index funds click here. When it comes to investment goals, mutual funds and index funds can both be used to achieve different objectives. Mutual funds provide diversification, lower fees, and the ability to earn higher returns than many other types of investments. Index funds provide low fees, diversification, and a way to track the performance of a specific market index. Ultimately, it is up to the investor to decide which type of fund best meets their financial goals and risk tolerance.
3. Mode of operation
- Index funds track a specific market index such as the S&P 500, and mirror its performance while mutual funds invest in a range of securities such as stocks, bonds, and commodities to provide investors with diversification benefits and potentially higher returns.
4. Diversification
- Mutual funds provide more diversification than index funds because they invest in a variety of investments which can help to reduce the risk of losses for investors.
5. Risk factor
- Index funds are often considered to be less risky investments than mutual funds due to their passive nature. This means that they will not have large losses from active management decisions. However, index funds may still lose money if the market index they track declines in value.
Index funds vs. mutual funds which has higher returns?
It is difficult to definitively say which type of fund has higher returns, as this depends on factors such as the type of investments in the fund, the fund manager’s skill, and the current market conditions.
Generally speaking, both types of funds can offer investors potential for higher returns than investing in individual stocks or bonds alone.
Index funds vs. mutual funds which is a better investment?
When it comes to investment goals, mutual funds and index funds can both be used to achieve different objectives.
Mutual funds provide diversification, lower fees, and the ability to earn higher returns than many other types of investments. Index funds provide low fees, diversification, and a way to track the performance of a specific market index.
Ultimately, it is up to you to decide which type of fund best meets your financial goals and risk tolerance and that will be the better investment for you.
But before you make your final decision, first take a look at the real time data and statistics on index funds vs. mutual finds on ICI, over the past years.
Conclusion note
Mutual funds and index funds are both excellent options for investors looking to diversify their portfolios and maximize returns. While each type of fund has its own advantages and disadvantages, they both offer low fees and the potential for higher returns than individual stocks or bonds alone.
With careful research, you can choose the fund that best meets your investment goals and risk tolerance.
