mutual fund index fund

The difference between mutual funds and index funds

The main difference between mutual and index funds is implied directly in their names. Mutual funds refer to the structure of the fund – multiple investors buy shares of the fund itself and a fund manager reorganises that money into a larger, mutually-shared portfolio. Index funds refer to the investment strategy taken – the entire fund is modelled on a particular index like the Dow Jones or S&P 500.  

Keep reading to learn more about both mutual funds and index funds, and which one is best depending on your own investment strategy.

What are mutual funds?

A mutual fund is a portfolio, often consisting of at least 100 securities, shared with other investors and managed by a professional who attempts to help the fund outperform typical market indices.

When investing in a mutual fund, investors do not own the securities directly but instead buy shares of the fund itself. Mutual fund stock portfolios are preferred by investors as an easier option than building a diversified portfolio themselves.

How much do mutual funds cost?

Most mutual funds require a minimum initial investment between $500 and $5,000. There are some mutual funds that don’t require an initial investment, but they are not as common. Thankfully, most mutual funds do allow investors to purchase more shares for any price after their initial investment. Investors can buy or sell shares of the mutual fund every day at market close. Income from the fund can also be automatically reinvested.

Once an investor has bought in to a mutual fund, the ongoing value of the fund is determined by the value of the securities in the portfolio at the end of each business day. This is also known as its net asset value (NAV) and is calculated by dividing the total amount of cash and securities in the portfolio by the number of shares. The NAV denotes how much each share of the mutual fund is worth.

It is also important to note that mutual funds have comparatively high fees associated with them as investors are paying a manager to actively buy and sell securities on their behalf. Investors should also consider these management fees when calculating potential profit from a mutual fund.

What are index funds?

An index fund is a shared portfolio created to match the composition of a financial market index, the most common three being the S&P 500, Dow Jones Industrial, and Nasdaq. These funds offer investors a low-cost way to invest in all the companies of a particular index. They also help balance out risk for investors as there is less volatility across an entire index compared to individual stocks.

Different index funds are weighted based on different qualities of the particular index they are modelled on. Some give equal weight to every company or sector included in the index, and others divert more or less weight to companies and sectors depending on their own weight within the particular index.

For example, an index fund based on the S&P 500, an index of the top 500 performing US stocks, typically diverts a higher percentage of money to stocks that are the largest or perform the best. So an index fund based on the S&P 500 would give the most weight to Apple (Nasdaq: AAPL), which accounts for 6.65% of the total S&P 500 and is the highest valued company on the index. 

How much do index funds cost?

The minimum initial investment for an index fund is usually between $1 and $3,000. Overtime index funds have low maintenance fees because investors are not paying as much for management as they would actively managed funds. Managers of index funds only trade securities when they need to rebalance portfolios to continue matching the index it’s based on.

The low expenses incurred when investing in index funds mean investors receive a greater amount of the fund’s profits than they would investing in an actively managed fund.

How are mutual funds different from index funds?

There are major differences between mutual finds and index funds. These include the initial costs and fees, how the funds generate income, and the general risk level of both funds. Reviewing these differences will help you understand which fund is best for your own investment needs.

Mutual funds are actively managed, meaning investors pay higher transaction and management fees for mutual funds than they would for passively managed funds. While investors pay more to own shares of mutual funds in the hopes for higher-than-average returns, their returns are cut into with high maintenance and handling fees associated with active funds.  

The amount of these costs is called the expense ratio. This figure is calculated by dividing the fund’s operating costs by the NAV. The average expense ratio for an actively managed fund is typically 0.5% to 0.75% while the average expense ratio for passive funds stays around 0.2%.

Mutual funds are slightly riskier than index funds as managers of mutual funds attempt to beat the general market indexes. While it creates opportunities for larger gains, it also opens the fund up for more potential loses.

According to the SPIVA scorecard from S&P Dow Jones Indices, passive-earning funds such as large-cap index funds regularly outperform actively-managed funds.

Whether an active mutual fund or passive index fund is the best option varies among investors depending on the amount of risk they are willing to take on and expenses they are willing to pay. The chart below directly compares key differences between mutual funds and index funds.

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