In the most traditional sense, investing is all about buying and holding individual stocks, sharing in the growth of companies as time passes. But if you’re like most new investors, you’re left to your own devices when it’s time to start choosing which stocks to own.
If you don’t have the time or understanding of the stock market to feel comfortable picking and managing your own individual stocks, a better option would be to look into stock funds that invest in a diversified group of companies. Two of the most popular types of these funds are index funds and mutual funds.
So, what are the differences between these types of funds, and which is better for you?
Both index funds and managed mutual funds provide exposure to a diversified portfolio of stocks, and often other equities, managed by some of the most respected experts on Wall Street today.
Although both are great options — especially for investors who simply don’t have the time or inclination to build and manage their own investment portfolio — there are key differences between the two.
There are costs any time you make an investment. Costs can vary wildly from one type of investment-grade fund to another as well as among separate funds of similar types.
Management fees associated with investment-grade funds are displayed to the investing public as expense ratios. These fees are a percentage of the average value of your investments over the course of a year. If a fund’s expense ratio is 0.45%, that means you’ll pay 0.45% per year to own that fund. In this example, if your average balance throughout the year was $10,000, you would pay $45 per year for the management fees associated with that investment.
These fees may seem small, but over the life of a long-term investment, they add up. High fees can seriously eat into your compounding gains, costing you thousands of dollars over the long run.
Index Funds Come With Lower Costs
When it comes to cost, there’s no real comparison. According to CNN, you can easily find an index fund with an expense ratio of less than 0.2%. Managed mutual funds are actively managed investment-grade funds, and active management comes with costs (detailed below). On the other hand, index funds are passively managed. This means the fund managers simply don’t have to do as much.
An index fund’s goal is to track the movement of an underlying benchmark index. For example, if you invest in an S&P 500 index fund, you’ll be investing in a portfolio that is composed of the constituents of the S&P 500.
Because the makeup of the S&P 500 doesn’t change much, there’s not much trading required in the fund. Moreover, because the stock-picking work is already laid out for the fund managers in the underlying index, there’s far less “management” required.
All told, this makes index funds one of the lowest cost ways to get into the market. In fact, the low cost and diversification involved in these funds is largely why Warren Buffet believes they are well-suited for most investors.
Pro tip: Before investing in either index funds or mutual funds make sure you do your research. Morningstar rates nearly all mutual funds and EFTs using their proprietary data points.
Mutual Funds Are More Expensive
Compared to index funds, mutual funds are far more expensive. With these types of funds, the managers in charge follow more aggressive strategies in an attempt to beat the returns of the overall market. To do so, they usually employ a rather large team including:
- The Fund Manager. The fund manager oversees the fund as a whole, working to develop strategies and making sure that the fund runs like a well-oiled machine.
- Analysts. Actively managed mutual funds will employ a team of analysts who are experts at diving into the data and finding the types of opportunities that the fund is interested in.
- Traders. Finally, these funds tend to be quite active, making moves in the market on a regular basis. Most active funds have a team of traders whose job is to follow the strategy outlined in the prospectus of the fund to buy and sell at opportune times to achieve higher-than-average returns.
The fact is there’s much more work involved in managing a mutual fund than there is in managing an index fund. As a result, there’s a much higher cost. With expense ratios for mutual funds often at 1% or higher, it’s important to look into the past performance of the fund compared to low-cost, passively managed options to ensure the higher fees are justified by a history of higher returns.
Investment Strategy Employed
If you talk to most successful investors about the investment strategy they follow, they’ll smile from ear to ear and be happy to tell you all about it. That’s because they know that it’s the investment strategy they follow that’s provided them the opportunity to achieve the level of success they have.
When placing your investment dollars in funds, the investment strategy that dictates the growth in your portfolio will be managed through the fund. There are key differences between the two fund types when it comes to the strategies they follow and what that means for your growth potential.
Index Funds Track Benchmark Stock Market Indexes
As mentioned above, index funds are passively managed investment portfolios that are designed to track the movement of an underlying index. These are portfolios built on diversification that essentially work to mimic overall market movement.
With such heavy diversification, your portfolio will generally be as safe as an investment in stocks can be. Should one or even a handful of the equities you’ve invested in fall in value, gains from the others will help to lighten the blow. Not to mention, the market is known to generate an average historical return between 8% and 10% growth per year, depending on which index you follow, which is a reasonable return on investment for any long-term portfolio.
Mutual Funds Actively Invest Based On the Strategies They Follow
Mutual funds are very different. Each fund will have its own investment strategy designed to beat the overall returns of the market. The strategy the fund follows will largely depend on the type of mutual fund you invest in and the views of the fund’s managers.
Some mutual funds will focus on a growth investment strategy, while others may put their efforts into value or income investing. Some funds look for domestic opportunities, while others look for opportunities to profit from the growth of emerging economies.
Before investing in any actively managed fund, it’s important to take the time to read the prospectus for that fund and get an understanding of what you’ll be investing in and the strategy the fund managers employ when making those investments.
Of course, different investment strategies will come with different risk levels, but active investing tends to be far more risky than index investing.
When you invest, you’re not just throwing your hard-earned money at the wall and hoping that it sticks; you’re putting your money to work for you in hopes of generating capital gains. So, when investing in an investment-grade fund, you’ll want to make sure you’re investing in a fund that’s known for generating meaningful profits.
Here’s how the two types of funds stack up in terms of returns.
With Index Funds You Become the Market
Index fund investing is commonly referred to as indexing, largely because when you invest in these funds, you’re essentially investing in the underlying index. These portfolios are born of diversification, which makes them safer — but there’s a tradeoff.
When taking advantage of this style of investing, you can expect to generate returns that are in line with overall market returns — nothing more, nothing less. So, if your intention is to beat the market, indexing isn’t going to be a good fit.
Conversely, if you’re interested in a slow, stable approach to investing, these funds are the way to go.
Mutual Funds Give You the Ability to Beat the Market
There’s a reason investors are willing to pay higher costs to invest in actively managed funds. The hope is that by paying more to have a team of professionals make it their life’s work to put together a portfolio that beats the market, you’ll generate higher returns by investing with them.
Sure, these funds are also diversified investments, which does protect you from some risk, but the management team behind the scenes is constantly looking for opportunities to generate outsize profits.
That sounds great, but it can be a double-edged sword.
There’s no question that there are plenty of mutual funds on the market known for generating better returns than benchmark averages, but active management also opens the door to increased risk. As such, it’s important to pay attention to historic performance before investing in any active funds.
Investing comes with risk. Even if you’re investing in Treasury bills — one of the lowest risk investments out there — you can lose money. So, it’s important to understand the risk you’re taking on when you make any investment.
Index Funds Come With Lower Risk
Although index funds are not without risk, they are the lower-risk option compared to mutual funds. Index funds track the movement of the whole market, and although bear markets do happen, the overall market is known for generating meaningful positive returns over the long run.
At the same time, when investing in an index fund, you effectively become the market. So you don’t have to worry about mistakes in your attempts to time the market or to pick winners and losers, which is exactly what actively managed funds do.
Managed Mutual Funds Come With Higher Risk
Managed funds come with significantly higher risk than passive funds. In the stock market, any time there’s potential to generate better-than-average returns, there’s also the potential for more significant losses should things go in the wrong direction.
To achieve the outsize gains they seek, portfolio managers use strategies that invest in various asset classes, look to opportunities in emerging small-cap stocks, and follow aggressive management styles. Ultimately, their name is on the line, and fund managers are typically willing to make aggressive moves to ensure that their name becomes synonymous with big gains.
Unfortunately, these aggressive strategies also open the door to higher levels of risk — yet another reason to dive into the fund’s track record before making an investment decision.
If you’re making money, you’re paying taxes, or at least you’re supposed to be. Money made in the stock market is not immune from a tax burden, so it’s important to understand the tax implications associated with the investments you’re considering before you make them. Here’s how these funds stack up.
Index Funds Reduce Tax Burden
Between the two options, index funds are more tax efficient. Gains from the stock market are taxed in two ways based on the amount of time the investments are held. Gains from investments held for under one year are taxed at your ordinary income tax rate, and gains from investments held longer than one year are taxed at a lower capital gains tax rate.
Because index funds are viewed as long-term investments, and they don’t change holdings very often, gains generated through these funds are generally taxed at the lower capital gains tax rate.
Mutual Funds Increase Tax Burden
In most cases, mutual funds come with a higher tax burden. The fact that these funds are actively managed means they are consistently cashing in on their investments and making new investments in an effort to yield fast-paced growth.
As a result, the vast majority of the return you’ll earn investing in these funds will be taxed at the higher ordinary income tax rate.
The Verdict: Should You Choose Index Funds or Mutual Funds?
When deciding whether to invest in managed mutual or index funds, it’s important to consider your unique risk tolerance, your goals, and the time horizon associated with your investment.
You Should Invest In Index Funds If…
Index funds are a better fit if you prefer passively managed funds and are looking for a way to minimize both risk and cost while generating stable returns. You’re the perfect investor for this option if:
- You’re Looking for Long-Term, Stable Investments. Actively managed funds may offer the opportunity to tap into larger returns, but that opportunity comes with increased risk. If you’re looking for a more stable investment opportunity to gradually build wealth or a retirement account over many years, index funds are going to be a better option.
- You’re New to Investing. Index funds follow a relatively simple strategy: invest in all assets of the underlying index to match its returns. As such, investing in these funds requires little research or understanding of individual companies or the market.
- You Don’t Want to Pay High Investment Management Fees. Fees associated with actively managed funds are much higher than those of passively managed index funds. While 1% fees may not sound like much, they can cost you tens or even hundreds of thousands of dollars over the course of your investment depending on the amount of money invested and the amount of time that money is put to work for you. Index funds come with lower fees, allowing you to hold onto more of your gains.
- You Want a Diversified Portfolio Consisting of Different Industries. The most common index funds are based on major indexes such as the S&P 500, the Nasdaq composite, or the Dow Jones Industrial Average. The S&P is designed to track the progress of the United States stock market as a whole, while the Dow tracks the largest publicly traded companies in the U.S.. By investing in these assets, you’ll gain exposure to the biggest players in just about every sector of the economy, from tech to consumer services and everything in between.
You Should Invest In Mutual Funds If…
Mutual funds are a better fit if you have a moderate to high risk tolerance and your goal is to beat the market. They’re suitable if you don’t mind doing a little extra research and you have some understanding of the stock market and various investing strategies. Consider investing in managed mutual funds if:
- You Have More Aggressive Investment Objectives. While these funds don’t come with the same level of risk as penny stocks or over-the-counter (OTC) stocks, they do come with more risk compared to indexing. Investors in managed mutual funds are willing to accept the increased risk because these funds aggressively work to beat overall market returns.
- You’re Willing to Do Additional Research. Actively managed funds employ professionals to manage the fund for you — that is what you pay for, after all. But even smart investing professionals are only human and can often be wrong. Instead of blindly diving into these funds, it’s important to do your research on them, paying close attention to past performance in comparison to overall market performance. Make sure the increased performance of the fund you choose outweighs the increased cost.
- You Have a General Understanding of Investing Strategies. Managed mutual funds follow specific strategies in order to achieve their goals. Because the strategy employed will make a major difference in the returns, or lack thereof, you’ll need to read the fund’s prospectus and have an understanding of the outlined strategy your money will be used to follow.
- You Have a Longer Time Horizon. Higher-risk investment opportunities are best in the early phase of your investment journey. As it gets closer and closer to time for you to cash in, you’ll have less time to recover should something go wrong. Mutual funds are far from the highest-risk assets on the market, but they attempt to beat the market by timing the market, which Hartford Funds claims to be impossible. Although “impossible” may be a strong conclusion, successfully timing the market is very difficult and comes with risks.
- You Want Access to Specific Industries or Strategies. If you’d rather dial down your investments to specific industries or use your money to employ strategies like growth or income investing, actively managed funds are the way to go. You can find managed mutual funds centered around just about any industry, strategy, or investment style you’re interested in.
Both Are Great If…
Both index funds and mutual funds are excellent options if you have a moderate tolerance for risk. Investing in both types of funds is appropriate if you’re not willing to take too much risk in your search for market-beating returns, but you don’t want to count yourself out of the race either. A mix of the two options is great if:
- You Are OK With Some Level of Risk. The management of risk is the name of the game in the market, but you’ll never know what it feels like to swim if you never jump in the water. Risk often comes with reward. Many investors who don’t want to choose individual stocks invest in a list of both mutual and index funds, tapping into the low-cost, stable gains offered by passively managed funds and taking advantage of actively managed funds in bull markets. It’s the best of both worlds, where risk exists but is minimized through heavy diversification.
- You Have a General Understanding of the Market. As mentioned above, investing in managed funds involves choosing funds whose goals and strategies align with yours. To understand just how the fund is investing, you’ll have to have a general understanding of the market as a whole.
- You Want to Supplement Broad Diversification With Another Strategy or Theme. By investing in index funds, you’ll gain exposure to the entire underlying index. But if you want additional exposure to income, value, or growth stocks in your portfolio, it’s a good idea to mix in some actively managed funds centered around the specific opportunities or investing styles you’re looking for.
Deciding how you’ll go about investing is a complex, yet crucial decision. Ultimately, whether you’re investing in managed mutual funds or index funds — or any other asset class for that matter — it’s important to make sure your investments line up with your objectives.
When choosing which direction to go, focus on your financial goals, risk tolerance, investment objectives, and time horizon. In doing so, you’ll invest in the assets that align best with you.
Moreover, while investment-grade funds provide heavy diversification, which reduces your risk, it’s important to do your research. Each fund comes with its own historic performance, expenses, and management team, all of which will play a significant role in your returns.