Index Funds vs. Mutual Funds

Are you interested in investing but you don’t know where to start? A mutual or index fund may be the way to go. While mutual funds used to be the clear choice, index funds are an increasingly popular alternative. Before you use your 401k or open a new account to invest with, know what sets an index fund apart from a regular mutual fund.

What is a mutual fund?

Mutual funds are a safe way to start investing. A mutual fund is technically a large pool of funds made up of several people’s investments. After you invest in a mutual fund, a money manager is in charge of investing your money into a variety of assets.  When it comes to investing with the funds, there are different approaches a fund’s money manager may take.

Here are the pros and cons.

Mutual funds take the pain out of investing. The advantageous aspect of mutual funds lies in the small initial investment: you can purchase a unit for as little as $50. Mutual funds are a great first foray into investing. Not only are they relatively cheap, they also don’t require extensive knowledge on individual investments such as stocks or bonds. There are plenty of funds, all with their own investment strategies; some managers will invest in sectors they believe have growth potential while others will buy stocks of well-performing companies. And for a low cost, you can have a diversified portfolio managed by an expert.

The security of a dedicated money manager makes the process hands-off, but you’ll pay for the convenience. Mutual funds carry an annual expense ratio, which is deducted from your account. The average charge for an actively managed fund is 1.5%; on the other hand, an index fund charges only 0.25%. As long as you aren’t investing with a tax-protected account (such as a 401k), you’ll also be taxed whenever the mutual fund sells holdings, even if they aren’t your own.

What is an index fund?

An index fund is a specific type of mutual fund.  Typically, index funds are focused on a particular market index; the Standard & Poor’s 500 Index is the most-followed, but many of index funds track other indexes, such as the Russell 2000. Unlike mutual funds, index funds don’t have a human manager. Therefore, the investing strategy is much more passive. They don’t regularly buy and sell holdings like mutual funds do; they follow the guidelines of a particular index instead.

Compared to a mutual fund, you will pay much less in fees and taxes. Since there’s no money manager, your annual expense ratio will be much smaller. There are also fewer turnovers with an index fund, which will save you from those annoying capital gains taxes. Index funds aim to outperform the market indexes they follow, granting you higher returns on your investment.

Here’s a drawback shared by both mutual and index funds: you have no control over what the fund invests in. If you aren’t interested in following particular companies, then you won’t be too bothered. However, if you’ve done some homework and wanted to invest in a certain company, you wouldn’t be able to do so within the fund. Your portfolio won’t be very diverse, and in the event of a down market, you have little to no protection.