The difference between mutual funds and index funds
There is a lot of difference between mutual funds and index funds that can make one a better investment option for you than the other. However, these funds also have a set of similarities. In this article, we will go over some of the main differences between these funds and how to decide which of the two tools is the best option for you.
What are index funds?
Index funds, or exchange-traded funds, are an investment vehicle that collects money from investors and uses that money to purchase a basket of stocks, bonds, and other securities. Investors can buy and sell shares in these funds just like they would buy shares on an exchange such as the Nasdaq or the New York Stock Exchange, hence the name of the exchange-traded fund.
These funds usually track a particular market index or commodity. These index funds are called index funds. However, there is a growing number of actively managed index funds, whose active manager attempts to outperform the benchmark by being more selective in its stock choices.
In return for the ETF providing the opportunity to benefit from the components of that fund, investors pay a fee to the fund company in the form of an expense ratio or a percentage of the assets under management. For heavily traded broad market index funds, in which the fund manager’s job is relatively simple, the expense ratio can be very low. For actively managed funds, in which investors pay for expert research and allocation management, the expense ratio goes up to a much higher level.
What are mutual funds?
A mutual fund is an investment vehicle that collects money from investors to purchase a basket of stocks, bonds, and other securities. Investors buy shares of a mutual fund directly from the company that issues the shares, such as Vanguard or Fidelity.
Mutual funds are often more actively managed than index funds, but you can also buy mutual funds that track a market index. Index funds generally charge lower expense ratios than actively managed index funds and expense ratios are often the same as their ETF counterparts.
Because you must buy and hold shares in a mutual fund with the fund company issuing the shares, you cannot transfer the assets to another financial institution without having to sell them.
The difference between mutual funds and index funds
The difference between mutual funds and index funds can have significant implications for investors. One big difference to consider is how the funds’ shares are priced. Because ETFs are bought and sold on an exchange, market forces dictate the value of the fund itself. If the fund is in high demand, it can be priced higher than its net asset value, which is the underlying value of the securities held by the fund.
The opposite is also true. If there is a sudden rush to sell shares of that particular fund, it may be priced below the net asset value. This is not a problem for most highly liquid ETFs. Compared to mutual funds, mutual funds are always priced at their net asset value at the end of each trading day.
Another important difference between mutual funds and index funds relates to tax efficiency. Index funds are usually more tax efficient than mutual funds because they are exchange traded rather than redeemed as is the case with a mutual fund company. This may not be the case with a mutual fund, where so many sellers will cause the mutual fund company to sell shares of the underlying security. This would have significant capital gains tax implications for all shareholders regardless of whether they sell or not.
Other differences between these funds include the ability to buy partial shares, commission fees, and minimum investments. Some mutual funds have very low minimums, and will go down further if you agree to invest on a regular schedule. Many online brokers have lowered their standard commission to $0 and allow investors to buy fractional shares, so you are not left with money on the sidelines.
You can easily reinvest profits from mutual funds just by checking the box, but the ability to reinvest profits from ETFs will depend on whether or not your broker offers a dividend reinvestment plan for your preferred fund.
The following table summarizes the most important points of difference between mutual funds and index funds
Investment funds
- Mutual funds trade at net asset value at the close.
- Mutual funds have varying operating expenses.
- Most mutual funds have a minimum investment.
- An investment fund has more tax liabilities than ETFs.
- Mutual fund shares can only be bought directly from the funds at the NAV price that is set during or at the end of the trading day.
- Compared to ETFs, there are zero transaction costs when buying or selling mutual fund shares.
- Mutual funds have less liquidity compared to index funds because it is related to the daily trading volume.
- Some mutual funds charge a penalty for selling a stock early. The time limit imposed on selling a stock is usually 90 days from the date of purchase.
- Mutual funds may track some indexes, but they are actively managed by professionals. The assets are selected in such a way as to outperform the benchmark and achieve higher performance.
Index funds
- ETFs are traded during the trading day and their value varies throughout the day.
- Index funds have lower operating expenses.
- There is no minimum investment.
- ETFs offer tax benefits to investors because of the way they are created and redeemed.
- Index funds can be bought and sold at any time on the stock exchange at the prevailing market price.
- There is an additional cost involved while trading index funds, which is called the “bid-ask spread” cost.
- The liquidity of index funds is related to the liquidity of the stocks included in the index.
- Index funds do not have a time limit for selling a stock, as the investor can buy or sell at any time of the trading day at the price available during that time.
- ETFs track an index, i.e. they attempt to match the price movements and returns indicated in the index by assembling a portfolio similar to the components of the index.
Are mutual funds better or index funds?
Understanding the difference between mutual funds and index funds can help you decide which is best for you.
Choose index funds
Tax efficiency is important to you. If you are investing in a taxable brokerage account, controlling capital gains distributions may be a deciding factor. If you’re investing in a tax-advantaged retirement account, tax efficiency is a moot point.
You are an active trader and would like to set limits and stop orders or use margin in your investment strategies. These options are available because ETFs trade just like stocks, but you cannot use these strategies with mutual funds.
You want to gain low cost exposure to a particular market niche without researching individual companies. Many ETF options measure niche market indexes. Although you can gain exposure through mutual funds, they are often less tax efficient or rely on active management, which increases their costs.
You can change brokers in the future. ETFs switch easily between brokers, but mutual fund positions must usually be closed out before changing brokers. You will then have to reinvest the proceeds in the mutual funds offered by your new broker.
Choosing investment funds
The ETFs you are considering are trading weakly. The limited liquidity of investment funds can lead to spreads between bid and ask levels, and often requires you to pay a premium above the fund’s net asset value. Mutual funds are always priced at net asset value.
You value the ability to outperform the market through active management. Although actively managed mutual funds do exist, they are few and far between. Most ETFs are index funds, which simply correspond to the market return. To outperform the benchmark, you need to rely on active management. However, keep in mind that these funds usually have higher fees and higher tax implications – and you can’t guarantee superior performance even with active management.
You are investing in less efficient parts of the market. Actively managed funds have the best potential to excel in these areas. Highly traded markets such as US large-cap stocks are very effective, but sectors with lower trading volume have much more potential to benefit from active management research and strategies.
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