Index Fund vs. Mutual Funds: The differences you should consider when choosing between the two.

There are a lot of factors to consider when investing in both index and mutual funds, but be it in management style, investments, and fees-index fund just seemed to beat mutual fund.

With the availability of financial platforms, services, and online brokers, you might be thinking of investing. And that is a good way of thinking, because if you study and become a smart investor, then the chance that you will profit from your investments will be better. Investing, though it involves risks, has a lot of opportunities to offer. As proof, it paved the way for the achievement of the financial goals of millions of people. So, unsurprisingly, many individuals like you want to invest.

But there is a preconception that investing needs a lot of time. So, you might be having second thoughts about whether to invest or not. And that is very natural, especially if you are working a lot and do not want to cut further any remaining significant time for your family and private life.  Lucky for you, there are forms of investments that require very little management; some even have people running them for you. Therefore, your first concern is solved.

Now, when it comes to investing, you typically think of stocks, bonds, options, etc., but there are other products and offerings you can choose from. If you aren't fond of investing in stocks and bonds, there are still many investment vehicles that can provide you with decent profits like funds.

Still, like any other investment, there are a variety of factors to consider when investing in funds. Factors like management style, cost, investments, and goals are things you should think of. So, while many active investors chose to claim stocks on big and multinational companies like Apple (AAPL), Tesla (TSLA), Facebook (FB), and Netflix (NFLX), there are still many good investment options for the passive investor like mutual funds and index funds.

So, what is an index fund? What is a mutual fund? Which is the better investment? In this article, you will learn and acquire the answers to all of those questions.

1. What is an index fund? What is a mutual fund?

Suppose you are torn between an index fund and a mutual fund. In that case, you need to thoroughly understand the similarities and differences between the two to make an informed investing decision.

The term "mutual funds" and "index funds" might be confusing, especially for new investors; some might even use them interchangeably. But the terms refer to two different things. "Mutual fund" refers to the fund structure, while "index fund" refers to the investment strategy. There are lots of index funds, but not all of them are structured as mutual funds. Consequentially, a lot of mutual funds are index funds.

It might not be very clear, but, in general, some mutual funds are index funds, and some index funds are mutual funds.

2. What is an Index Fund?

The term "index fund" refers to the approach to a fund. An index fund is a fund that has a portfolio designed to track or match key benchmark indexes. An index tracks the performance of stocks, bonds, and assets. An example of an index is the broad-based S&P 500, which counts the stocks of 500 of the biggest corporations and companies in the United States of America.

It is said that index funds provide broad market exposure, low expenses and fees, and low portfolio turnover. An index fund reflects the performance of the assets in an index, and it does not try to beat the market. This makes an index fund a mirror of the risk and return of the market. If the index rises, then the index fund rise (rise the same percentage most of the time), and if the index drops then, the index fund drops as well (drop the same percentage most of the time).

Index funds are also suitable for diversifying your portfolio. It allows investors to invest in big companies without them having to invest in them individually. Once they choose a fund, they have to fund it, and then, they can already do their other things. An index fund is a passive investment. It requires very few investment decisions since it is simply tracking an index and particular securities.

3. What is a Mutual Fund?

Mutual Fund is the structure of the investment. Historically, mutual funds have been one of the more favored investments. Like an index fund, a mutual fund is also suitable for diversifying your portfolio. It invests in different securities like stocks, bonds, and others which makes it less risky.

To invest in stocks, bonds, and other securities, mutual funds pool money from a group or collection of investors. But compared to a passive index fund, a mutual fund is actively managed not by the investors but by fund managers who pick investments and profits through shareholder fees.

Shares in mutual funds are called mutual fund units. Investors buy these mutual fund units in their net asset value (NAV or NAVPS) per share. NAV or NAVPS is computed by dividing the value of securities by the number of outstanding shares.

4. Comparison between Index Fund and Mutual Funds

Based on the above explanations of mutual and index funds, one can already see that the two have differences. The most profound among these differences is the nature of index and mutual funds. Index funds invest in particular securities in an index; on the other hand, mutual funds invest in a changing list of securities based on the investment manager's choice.

This difference between the two has particular effects like the following:

·       Index funds want to have average-market returns since they are just mirroring the index, while mutual funds through the manager and changing investments are trying to beat the market

·       Mutual funds, because of the active management, have higher fees

·       The performance of index funds, in the long run, will relatively become predictable, while the same cannot be said for mutual funds

·       Over time, investors can have more significant returns in the index funds due to several factors, including the lower amount lost in fees.

The table below gives a look at the key differences between the two

5. The Positives and Negatives of an Index Fund

Positives

• · Low Fees. Unlike mutual funds, which are actively managed, index funds tend to be more cost-efficient. Investors do not need to pay a fund manager in an index fund, which is the case in mutual funds. In addition, the companies that handle index funds do not need to pay staff for finding worthy investments since it automatically reflects the index's performance. Therefore, index funds charge lower expense ratios compared to mutual funds.
• · Diverse Portfolio. Since index funds invest in different securities like stocks, bonds, and others, it is a good vehicle for diversifying your portfolio. It provides investors a broad market exposure, allowing them to invest in different companies without individually investing in each of them. Therefore, the investors' money is not invested on few companies or particular securities, reducing the risk.
• · May outperform active management. Not all index funds are the same in performance; some fare better than others. But many index funds have good performance. One of the more popular indices, the S&P 500, which includes 500 of the biggest companies in the US, outperformed many investors so many times.
• · Better long-term returns. Since the expense ratio is lower, the funds' profit has fewer reductions, leading to better returns. But this is only one of the factors. The strategy of index funds is to match the risk and return of the market on the assumption that the market always wins bears positive results in the long run. For example, according to the data of SPIVA Scorecard from S&P Dow Jones Indices, for five years (ending in 2019), 80% of large-cap funds posted returns lower than that of S&P 500.

Negatives

• · May track a poor-performing index. Since not all indexes are equal, there will be some poor-performing indices. And if investors are investing in a poor-performing index, then the chances of poor returns will be high.
• · Limited gains.  The return of index funds is limited. Though more profitable in the long term, index funds tend to be outperformed in shorter periods.

6. The Positives and Negatives of a Mutual Fund

Positives

• · May outperform the market. Mutual funds can beat the market sometimes, but it is rare for investors to beat the market return in the long term.
• · Diversified Portfolio. Just like an index fund, mutual funds can offer a diversified portfolio to investors.
• · Human element. Because of the managers who actively managed it, mutual funds have a human part in them. The manager provides investors the advanced portfolio management skill that is needed in managing an investment portfolio. This human element also provides flexibility to the fund.

Negatives

• · Higher expense ratio. Investors need to pay management fees because of the professional manager who manages the mutual funds.
• May underperform the market. Active management, which is common in mutual funds, has a higher chance of underperforming the market in the long run.

7. Conclusion

If you are a beginner by now, deciding between mutual and index funds should be a no-brainer. Mutual funds and index funds have advantages and disadvantages, but the latter has a clear edge over the former. It outperforms actively managed funds in the long run, has lower fees and other positive perks. In conclusion, it is one of the best investments for you who are just starting.