Mutual fund vs Index fund: What’s your investment flavor

mutual fund vs index fund

Written by Aryan Agarwal

August 4, 2020

Reading so many articles related to mutual fund investing is difficult with all the information they give and confusing you about where to invest.

New investors, when thinking of investing in mutual funds, are always confused about mutual fund vs index funds and what’s the difference between them.

So we have written this guide on index funds vs mutual funds for beginners.

What is a mutual fund?

What is mutual fund

A mutual fund is a pool of money that is collected by huge financial companies to invest in securities and assets like stocks, bonds, commodities, etc.

These funds are managed by professional managers who have degrees from top universities and experience in the stock market, who allocate the capital available to them to attempt to produce capital gains for the investors.

Therefore, these financial instruments allow access to small or individual investors, access to professionally managed portfolios, and their investing experience. Each mutual fund holder, therefore, participates proportionally in the capital gains or loss of the fund.

What is an index fund?

What is an index fund

A stock index is an index that measures the performance of a basket of securities intended to replicate a specific area of the market, such as the S&P 500, DJIX.

An index fund is a type of mutual fund that mirrors and tracks a stock market index like the S&P 500.

An index fund can track any index comprising of stocks, bonds, and other investments. These funds are designed to be passive funds that track the underlying index.

Index funds have lower fees than typical mutual funds as they are passively managed because they need to maintain a portfolio as same as the index.

How do mutual funds work?

Mutual funds are managed by professional money managers, and these managers actively traded stocks to ‘beat the market’ by getting higher returns than the stock market index.

Once you invest your money in equity mutual funds, the money managers take that money and invest in the stock market.

Mutual funds can hold any type of securities like gold, bonds, stocks, etc.

Mutual funds are a broad category, but most of them are actively managed funds, and its portfolio is continuously traded and rebalanced.

Actively managed funds have an expense ratio and fees known as MER between 0.5% to 2%.

The gains and losses that the stocks give are directly passed over to the investor.

How do index funds work?

Index funds are also managed by professional money managers, but they only track the underlying index. If the index tracks bonds, then the index fund will track bonds.

An index fund is passively managed as the index doesn’t regularly change, so the portfolio doesn’t need to be constantly be changed.

As managers don’t have to make decisions and only copy the index, its MER is very low, which is between 0 to 0.5%.

Investment goals

If you lazy and like shortcuts, then you should invest in index funds right away. On the other hand, if you like to research and want to invest, you can try to find a good mutual fund that meets your needs and will beat the market based on your analysis.

If your goal is to increase wealth over time and don’t want to take any risk, then index fund is the best option for you because you certainly won’t beat the markets with this strategy. Still, you also won’t underperform the market.

Load and Fees

Most index funds are ETFs, which means that they are traded on the stock market just like stocks are. Therefore, they don’t have any load or very minimal load(negligible) fees.

Vanguard is the most famous company in index funds as it charges negligible fees from the customer. Their index fund(VOO) charges only 0.04%, which feels like nothing.

Mutual funds, on the other hand, have multiple fees associated with them. They need to pay entry load fees, which are around 0.5 to 1%. Then there is a lockin period where, if you exit before that time, you will have to pay exit load fees. Their MER can be around 0.5 to 2%, depending on the mutual fund you choose. That means that the total fees you pay to a mutual fund can vary from 0.5% to 3%.

Performance

Sadly, paying all the extra fees to the mutual funds don’t help the investors get a better return as a study shows that between 2001 to 2016, only 10% of mutual funds managed to outperform the index fund.

Index fund performance is better than actively managed funds, as we can see in the study.

This may be because they charge a lot of fees that eventually cause their own downfall as taking 2% fees means that they need to make 2% more than the index fund just to match their performance, which can be hard.

Lower fees are the primary and most significant advantage index funds have over actively managed funds like mutual funds because index funds do not need continuous monitoring as mutual funds do.

Risk

The risk from a security purpose is pretty minimal as all the investments in index funds or mutual funds are secured by government insurance.

Like any investment, you can lose your money after you invest due asset falling in value or falling stock market depending on the investment you make.

Stock can fall due to natural disasters, inflation, recession, pandemics, etc. Market risks are known as systematic risk, as even diversification can fail if the whole stock market falls down.

Some funds can have liquidity issues when you want to exit the fund. That means that when the seller is not able to find a buyer in the market to sell the order.

Sometimes due to a lack of buyers in the market, you might be unable to redeem your investments when you need them the most. The best way to avoid this is to have a very diverse portfolio and to select the fund diligently.

As mentioned in the study above, the best risk-free way to invest your money will be through index funds, as they will give you consistent returns that are par with the stock market.

How to invest in mutual funds

You can invest in mutual funds by opening an account with the investment firm or bank that offers the mutual fund. It is necessary to open an account with them before purchase a mutual fund.

Mutual funds are bought in dollar amount, unlike shares that are bought by units of shares. Before purchasing any fund, if you have the option, try to select a ‘no load’ fund.

No-load fund means that you won’t have to pay any sales commission to anyone, and that means all your money is invested.

Also, look for MER before investing.

How to invest in index funds

For investing in an index fund, you will need a brokerage account, which can be the same account that you may have for stock trading. Popular apps that you can use are Robinhood, webull, m1 finance if you dint have any brokerage accounts.

You need to buy a whole unit of the index fund unless your brokerage allows fractional shares, where you can buy index funds based on their dollar value, just like actively managed mutual funds.

Index funds have low fees but take care of the liquidity and size of the fund as there can be liquidity issues in smaller funds.

Pros and Cons of Mutual fund vs Index fund

Mutual FundIndex Fund
AffordableLow risk and steady growth
LiquidityLow Fees
Fees and expensesNo flexibility
Lock-in periodNo big gains
Pros and Cons of Mutual fund vs Index fund

Pros of Index Funds

Low risk and steady growth

Index funds have low risk as they are designed for steady long term growth. They are diversified, represent many different sectors within an index, which protect losses.

Low fees

Index funds have low or negligible fees, as we discussed earlier.

Cons of Index Funds

No flexibility

There is no flexibility as the portfolio manager has to match the index exactly and cant make their own decisions.

No big gains

An index fund will never outperform the market as it tracks the market index and will only return whatever the market returned.

Pros of Mutual Funds

Affordable

Investing in a mutual fund is affordable as you can buy according to dollar value, and most mutual funds have a minimum deposit of only $50.

Liquidity

Mutual funds won’t have to see if there is a buyer for your fund. You can sell it and get money in your account in a maximum of 2 days.

Cons of Mutual Funds

Fees and expenses

Mutual funds charge a lot of fees for their expenses and commissions. This can cause you to lose money.

Lock-in period

Many mutual funds have a lockin period where if you exit before it, you will have to pay an exit load to the mutual fund company.

Taxation

Both mutual funds and index funds have to pay taxes on the capital gains if there are any. Depending on the time period you hold it, you need to pay short term capital gains or long term capital gains.

Although index funds are more tax-friendly as they are structured differently than actively managed funds because mutual funds have to continually rebalance the fund by selling securities to accommodate shareholder redemptions. While index funds have units where when you sell the whole stocks of that shares are sold.

This means that when mutual funds rebalance, they need to pay more transactional taxes than an index fund.

Dividends of both index funds and mutual funds are taxed as ordinary income. To learn more, check out fidelity. They have explained it in depth.

Mutual fund vs Index fund: What should you buy?

Most investors will be happy buying index funds over mutual funds due to the stability that the index funds give. They are designed for long term growth without any hassle. They offer fewer fees and are easier to trade.

Experienced investors with specific needs should check out mutual funds as they are not inherently bad or anything. You just need to have a bit of experience to know what you want and which fund can provide you with it.

Conclusion

For beginners deciding between index funds vs mutual funds, it should be no brainer question now to select index funds.

Index funds outperform actively managed funds, have fewer fees, better taxation, and everything.

It is the best investment for someone just starting out.

Let me know where you would like to invest between mutual fund vs index fund.

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