Difference between Index Funds and Mutual Funds

The stock market has always been volatile and completely unpredictable, hence, making a desired return on the investment is not a cakewalk for new investors. Even if, you have been investing in the stock market or mutual funds for years, nevertheless a tiny mistake that could obstruct achieving your investment goal or sometimes leads to even loss.

Therefore, if you are a beginner, it is always recommended to invest through mutual funds. You must have heard the terms ‘mutual funds’ and ‘index funds’; when it comes to an investment vehicle. And it’s possible to get mixed up between the words “mutual fund” and “index fund.”

This article intends to ellaborate the difference between index funds and mutual funds based on various significant perspectives.

Index Funds & Mutual Funds –

The terms “mutual fund” and “index fund” refer to different aspects of a fund: “mutual fund” refers to the composition of the fund, while “index fund” refers to the investment approach. Many index funds are organized as mutual funds, but not all of them are, and many mutual funds are index funds. In general, an”index fund” is a fund whose investments closely follow a market index.

In contrast, a “mutual fund” is a broad category of investment funds that employ a variety of investment strategies. To make an informed investment decision, you must first consider the similarities and difference between mutual funds and index funds.

Index Funds:

The word “index fund” refers to a fund’s investment strategy. It is a fund that seeks to replicate the success of a specific stock index, such as the S& P 500 or Russell 2,000. A more actively managed fund, on the other hand, is one in which a fund manager selects investments in an effort to outperform the market which happens to be the primary difference between index funds and mutual funds.

An index fund seeks to balance the market rather than beat it. Individual retirement plans (IRAs) and 401(k) account commonly use index funds as their primary portfolio assets. Legendary investor Warren Buffett has suggested index funds as a safe haven for retirement savings. He has claimed that rather than choosing particular stocks to invest in, the average investor should buy all of them.

Mutual Funds:

The word “mutual” in the phrase “mutual fund” refers to the fund’s structure rather than the investment policy pursued by the fund’s shareholders. This form of fund pools the funds of investors who want to buy and sell securities together.

Investing in a Mutual fund is not trading shares of discrete companies held by the mutual fund; it is trading shares of the mutual fund company itself. Investors purchase 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.

Index Funds vs Mutual Funds (Comparison Table)

The comparison table aims to elucidate the difference between index funds and mutual funds by comparing different aspects –

In Index Fund, the investment’s main aim is to complement the investment return of a benchmark stock market index.The main objective of investment in Mutual Funds is to outdo the investment return of the analogous benchmark index.
Invests majorly in the stock market, bonds & other securities.Mutual funds also tend to invest in bonds, stocks & other securities.
The Index fund’s management style is passive and automated to comply with the exact holdings of the standard holding.In the Mutual funds’ case, the management style being active is chosen by the fund analyst.
The average management expense ratio in an Index fund is 0.09%The average management expense ratio in the Mutual funds happens to be 0.82%
The after-fee return of $1,000 annual investment earning 7% average annual return over 30 years in an Index fund is $99,000.The after-fee return of $1,000 annual investment earning 7% average annual return over 30 years in the case of Mutual funds is  $86 000.
The average amount that is lost in 30 years over fees is $1800.The average amount lost in 30 years over fees is $15,000.

Difference between Index Funds and Mutual Funds:

The above-given points are explained with a broader perspective as under so as one can comprehend the primary difference between the index fund and mutual fund.

1) Investment Goals –

Index Fund –

An index fund’s sole investment goal is to replicate the success of the underlying benchmark index. When the S& P 500 zags or zigs, an S& P 500 index mutual fund does as well. An actively managed mutual fund’s investment aim is to outperform the market — to gain higher returns by making analysts carefully select investments they anticipate will increase overall results.

Mutual Fund –

To outperform the index, investors can prefer an actively managed fund over an index fund. However, you’ll pay a higher price for the manager’s experience in return for potential outperformance, which brings us to the next — and perhaps most important — the distinction between index funds and actively managed mutual funds: cost.

2) Cost –

Index Fund –

Index fund charges as well, but the fact that it is automated to comply with the standard benchmark stock market, the cost is on a lower side than the actively managed and engaged Mutual Funds. That’s why index funds, as well as their smaller counterparts, exchange-traded funds (ETFs), have become well-known for their lower investment costs when compared to actively managed funds.

Mutual Fund –

It is more expensive to have people in control of the show. Investment manager wages, bonuses, employee benefits, office space, and marketing materials are all expenses that must be covered in order for the mutual fund to draw more investors.

Investors pay more for actively managed mutual funds in the hopes that they can outperform index funds. However, the higher fees investors pay eat into the fund’s returns, causing the bulk of actively managed mutual funds to perform poorly.

4) Management Style –

As mentioned above, the management styles of the Index fund and Mutual fund are passive and active, respectively. Let’s dive deep into the understanding of ‘Passive’ and ‘Active’ Management Style.

Passive Management-

An index fund’s assets are automated to track an index — such as the Standard& Poor’s 500 — so if a stock is in the index, it will be in the fund as well. This eliminates the need for active human control when deciding which stocks to buy and sell. Index investing is considered a passive investing strategy since no one is actively monitoring the portfolio — performance is purely dependent on price fluctuations of the individual stocks in the index, not on anyone trading in and out of stocks.

Active Management-

All investment decisions are taken by a fund manager or management team in an actively managed mutual fund. They have full freedom to select assets for the fund from a range of indices and investment styles, as long as they obey the fund’s specified charter. They decide which stocks to buy and how many shares to sell from the portfolio. This is where the trouble for actively managed mutual funds begins.

Conclusion –

The burden of payments, however, does not stop with the cost ratio. Since it is deducted from an investor’s annual gains, less money is left in the portfolio to compound and expand over time. It’s a double-whammy charge, and the cost can be very high. With the passing days, an Index fund is getting more popular for its low investment cost. Previous records have shown that it is eventually difficult to beat the market returns.

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