Understanding the Difference Between Index Funds and Mutual Funds
Depending on your financial goals, one can be more tax-efficient and low cost, making it a better investment.
Investments are just one of the ways that you can build your wealth, save for retirement, or manage your money for the future. But knowing the difference between portfolio types and which if worth considering can be confusing, especially if it's your first time investing. This is why it is a good idea to seek out a financial advisor before you put any plans into action. A professional can help you navigate the world of investing and answer questions specific to your situation.
Here, we talked with Julie Virta, CFA, CFP, senior financial advisor with Vanguard Personal Advisor Services to find out the differences between index funds and mutual funds.
The Differences Explained
First and foremost, what is a mutual fund? "A mutual fund is a professionally managed collection of individual stocks, bonds, short-term investments, or a combination of these asset classes. The portfolio manager directs the fund to obtain its objective," explains Virta. "For an index fund, the goal is to track the performance of a particular index, while an actively managed fund aims to outperform its benchmark. Every investor in the fund shares proportionally in its investment returns, which includes income via dividends or interest, and capital gains or losses caused by the sale of securities held in the fund."
Index funds are a type of mutual fund that focuses on "the performance of a specific market benchmark—also called an index—as closely as possible," she explains. These funds are also referred to as ETFs or exchange-traded funds. "Instead of choosing which stocks or bonds the fund will hold, the fund's manager simply buys all of the stocks or bonds in the index that it tracks," Virta says. "Funds tracking the S&P 500 index are perhaps the most well-known index funds, but there is a broad range of index funds that seek to track all of the major sectors, styles, industries, and countries of the global investment marketplace."
In contrast, a mutual fund is generally a managed fund; this means that the investments are actively managed and may hold a variety of market benchmarks from different indexes. Portfolio managers have a goal to "outperform their benchmarks and peer group averages" for the mutual fund.
Which Should You Invest In?
The answer to that question depends on your financial goals. Both funds offer numerous benefits. According to Virta, an index fund (which is a type of mutual fund) is great for achieving savings goals retirement, education, or buying a home. "The specific investments should be dependent on each investor's personal circumstances, such as goal and time horizon," Virta says. "For example, a young investor saving for retirement should take more equity risk (allocate more to stocks than bonds) than an investor who is near retirement age." Index mutual funds also offer a lot of tax benefits.
It's also important to consider tax-efficiency. Index funds tend to have "fewer taxable capital gains being realized or distributed. This is particularly important for funds held in taxable accounts," explains Virta. So, the amount of taxes you'd have to pay on these funds may be lower than how much you would be paying in taxes for other types of funds. Index funds tend to have lower fees than other types of funds. "In addition to their tax efficiency, index funds offer meaningful cost advantages in that they tend to have lower expense ratios because it costs less to run an index fund than an actively managed fund, and lower transaction costs because they trade infrequently, employing a buy-and-hold approach," Virta says.
Another thing to consider? Broad diversification. While the concept of an index may seem very focused, the portfolio will contain a diverse mix of investments to offer some protection against the ups and downs of the stock market. Of course, this does not mean that it can prevent loss from broad market declines but it can help buffer from smaller stock market bumps.
However, if you want to have someone manage your portfolio and make your investments in increments over the course of several years, then a traditional mutual fund could be the way to go. You can increase the amount you invest instead of investing a particular sum at once. "Actively managed funds can also be a valuable component of a balanced portfolio," says Virta. "While Vanguard is known for being the indexing pioneer, today we are one of the world's largest active managers with more than $1.6 trillion in active funds under management. We've seen great success with our active fund lineup by focusing on keeping costs low, just as we do with our index funds."