5 Differences Between Index Funds and Mutual Funds I’m Glad to Finally Know
- I recently decided to ditch all of my individual stocks in favor of indices and mutual funds.
- However, I was curious: what exactly is the difference between an index and a mutual fund.
- The biggest differences seem to be their cost and how they are managed
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My journey as an investor started only a few years ago. After repairing the damage I caused to my finances in my 20s, I entered my 30s on a mission to make smart decisions with my money. Once I built up my savings account, emergency savings account, and retirement fund, I decided it was time to invest in the stock market.
I started buying stocks in random companies that I was interested in and before I knew it I had invested a few thousand dollars in over 20 individual companies. It was a big mistake. I didn’t know what I was doing and I wasn’t following the market to know when to buy more or sell.
In an effort to get away from investing in individual stocks, I wanted to invest in index funds or mutual funds. The problem was that it seemed too confusing to even know where to begin. That’s why I asked financial experts to explain to me the main differences between index funds and mutual funds. Here’s what they had to say.
1. An index fund can be a mutual fund
Although it may seem confusing, Clayton Wood, a financial planner, says it’s a good first step in understanding that a
is a mutual fund, but a mutual fund is not always an index fund.
“A mutual fund is the pooling of money from multiple sources to invest in a pool of investments typically managed by an asset manager,” Wood explains. “A mutual fund’s investments are guided by its investment objectives, which can be found in the fund’s prospectus.”
So how is an index fund different from a mutual fund? Wood says an index fund is a pool of money that invests in a portfolio that tracks an index, like the S&P 500.
“The index fund’s investment objective is to mirror the investments and allocations of the index that is chosen,” Wood said.
2. Index funds have lower expenses
As for fees, Alvin Carlos, a financial planner, says index funds are low-cost mutual funds.
“It’s the Costco of investing,” Carlos said. “Index funds’ fees can be 10 times lower than a mid-priced mutual fund. Plus, index funds can give you better returns than a mutual fund.”
“Studies show you can make more money investing in low-fee index funds compared to higher-fee mutual funds,” he added. “Over 82% of mutual funds have underperformed an S&P 500 index fund over the past 10 years.”
3. They have different themes
Depending on how much risk you’d like to take and how much you’d like to diversify your investment portfolio, Jay Kirkwood, a financial planner, says it’s good to know the different themes of index funds versus mutual funds.
“An index fund will track a specific index of stocks. You may be familiar with some like the Nasdaq, S&P 500 and Dow Jones,” Kirkwood said. “Other mutual funds may focus on a specific theme such as emerging markets and growth stocks.”
4. Mutual funds are managed by professionals
If you’re looking to have a professional in charge of your investments, Amy Richardson, financial planner at Schwab Intelligent Portfolios Premium, says mutual funds are managed by professional fund managers for a fee.
“With actively managed funds, managers invest with the goal of beating a benchmark. The costs of actively managed funds are generally higher given the potential for outperformance,” Richardson said. “Most actively managed funds are mutual funds, but there are also many index mutual funds.”
5. Mutual funds experience capital gains distributions
One of the biggest differences between mutual funds and index funds is when taxable events occur for each.
“The Mutual Fund Experience
distributions which is a taxable event for an investor (even if the shareholder has not sold any of their shares) whereas ETFs generally do not,” explained Richardson. “Mutual funds are required by law to pay capital gains distributions to shareholders.
“The distribution represents the net gains from the sale of investments throughout the year in the fund,” she added. “Because ETFs are generally passive investments that track an index, an investor generally does not realize a taxable event until they sell their investment.”