Investment-grade funds have become a preferred way for retail investors to access the stock market. These funds pool investment dollars from a large group of investors to make investments according to the fund’s prospectus.
Investors share in both price appreciation and dividends from their investments without having to manage diversified portfolios featuring a long list of assets on their own.
The two most common types of investment-grade funds are known as index funds and active mutual funds. But what’s the difference? And which should you add to your investment portfolio?
Index Funds vs. Active Mutual Funds – Differences Between These Investments
Index funds and active mutual funds are similar investment vehicles. Both types of funds use pooled money to make investments according to their prospectus. Both also tend to stick with the same asset classes including stocks, bonds, and other securities.
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But there are a few main differences between the two.
In particular, index funds and active mutual funds follow different investment goals, are managed differently, and come with different sets of fees. See the chart below for a glimpse of these key differences:
|Index Fund||Active Mutual Fund|
|Investment Goal||Seeks to track the performance of an underlying market index.||Seeks to produce better returns than the underlying index.|
|Management Style||Passive management.||Active management.|
|Costs||Low fees.||Higher fees.|
Index funds are a type of mutual fund or exchange-traded fund (ETF) that tracks the returns of an underlying benchmark index like the S&P 500, Nasdaq, or Dow Jones Industrial Average.
For example, the Vanguard 500 Index Fund (VFINX) is an S&P 500 index fund. The fund seeks to produce the same returns as the S&P 500 before accounting for fees.
Investment Objectives of Index Funds
Index funds seek to provide shareholders the same returns as the underlying indexes they track. This is done by investing in the same assets that are listed on the index.
When the composition of the underlying index changes, so too do the holdings in the index fund, but this doesn’t happen often. Some indexes are adjusted quarterly while others are adjusted annually, but most investments held in index funds are held for multiple years, which offers tax benefits.
Management Style of Index Funds
Index funds produce the same returns as their underlying indexes by investing in the same assets that make up the index they track. As a result, the fund managers at the helm of these funds don’t have much work to do to keep the fund on track.
All index fund managers need to do is make sure the fund maintains the same weighted exposure to the same stocks as its underlying index. They may have to rebalance occasionally, but they don’t need to do in-depth research to pick the assets they want to add to the fund — those decisions are automatic.
These funds are generally considered passive investing funds because they require less work on the fund manager’s behalf than active funds.
Costs of Index Funds
Both index funds and mutual funds charge an expense ratio, which describes the fees investors pay on an annual basis to be part of the fund.
One major benefit to passively managed index funds is that they come with significantly lower fees than actively managed funds like active mutual funds. This is to be expected because index funds require far less management than active mutual funds.
Advantages & Disadvantages of Index Funds
Index funds come with perks and drawbacks like any other investment vehicle. Consider these most significant advantages and disadvantages before you invest.
Some of the biggest advantages to investing in index funds include:
- Heavy Diversification. Index investing means your portfolio will have exposure to hundreds or even thousands of assets because index funds invest in every single asset included in their underlying indexes. This diversification protects you from significant declines should one or more of the assets in your portfolio take on water.
- Lower Cost. Index funds offer a low-cost investing experience. The fees on these funds are generally a fraction of the fees charged on active mutual funds.
- Professional Management. You don’t have to worry about managing your investments because the pros handle that for you.
- Lower Tax Burden. Most assets in index fund portfolios are held for several years. Gains from these investments usually qualify for lower capital gains tax rates rather than being taxed as ordinary income.
After reading the advantages, you may be ready to jump on index funds, but there are some drawbacks to consider too. Some of the biggest disadvantages of investing in index funds include:
- You Won’t Beat the Market. With index funds, you become the market because of the heavy diversification in their portfolios. It’s impossible to beat the market when your portfolio simply mirrors it.
- You Relinquish Control. You own shares of the index fund but the fund manager controls your investments. The manager also holds your voting rights with the companies the fund invests in. You won’t have any say in any individual company’s votes on acquisition offers, changes to management, and other actions shareholders vote on.
Active Mutual Funds
Active mutual funds are a type of mutual fund that seeks to produce better returns than those produced by their benchmark index before accounting for fees. For example, an active mutual fund with the S&P 500 market index as a benchmark will attempt to produce better returns than the S&P.
Investment Goal of Active Mutual Funds
Active mutual funds attempt to produce better returns than their benchmark indexes using a wide range of investment strategies to achieve their goals. The strategies used in a particular fund are outlined in its prospectus.
Management Style of Active Mutual Funds
As their name suggests, active mutual funds are actively managed. Unlike index funds, active mutual funds generally have a large team that includes the portfolio manager, a group of analysts, and a group of professional traders.
Whereas index funds only buy and sell securities when their underlying indexes are adjusted, active mutual funds are constantly looking for the next opportunity to generate a profit in the market. This means mutual funds generally hold assets for a shorter period of time than do index funds.
Costs of Active Mutual Funds
Active mutual funds require more manpower than index funds, a fact that’s seen clearly in the management fees they charge. Active funds are known for higher expense ratios than index funds. The higher fees cover the cost of the teams of professionals required to manage these portfolios.
Active mutual fund fees are substantially higher than index fund fees, but their results don’t always match. If you choose to go the actively managed route, look into the fund’s historic performance and its fees to make sure you’re getting what you’re paying for before you invest.
Advantages & Disadvantages of Active Mutual Funds
There are several pros and cons to consider before diving into active mutual funds. Here are some of the most important.
Some of the biggest advantages to investing in active mutual funds include:
- Potentially Higher Returns. The goal of active funds is to beat the returns of the underlying index. Therefore, it’s possible to beat the market with the right mix of these funds.
- Hands-Free Investing. You don’t have to be a pro to invest in mutual funds because a team of professionals manages your investments for you.
- Effective Access to Under-Researched Markets. Mutual funds are particularly useful if you’re interested in investing in emerging markets or industries. A team of analysts and professional traders with the research skills needed to make winning moves in less commonly researched markets choose investments that have the right balance of risk and reward.
Sure, there are plenty of perks to investing in active mutual funds, but there are also a few big drawbacks to consider. Those include:
- Higher Risk. Active mutual funds aren’t as diversified as index funds. They’re also actively managed by human beings, and humans have been known to make mistakes. So, you’re accepting a higher level of risk when investing in actively managed funds.
- Higher Fees. Active mutual funds have substantially higher expense ratios than index funds, so unless the fund produces a meaningful improvement in gains, it could result in a lower net return than a comparable index fund.
- Higher Tax Burden. Active mutual funds usually make short-term moves in the market. As a result, gains from these investments are often taxed at your ordinary income tax rate instead of the lower capital gains rate.
The Verdict: Should You Choose Index Funds or Active Mutual Funds?
You should consider your investment objectives, risk tolerance, and research abilities when deciding whether index funds or active mutual funds are your best option.
You Should Invest in Index Funds If…
Index funds are a better fit if:
- You’re New to the Market. Index fund investors can expect returns similar to those of the overall market or sector the fund is based on. This is a perfect way for newcomers to access the market while learning the art of investing.
- You’re Risk-Averse. Index funds are the lower-risk option because they have more diversification and hold positions for a longer period of time. They’re a great fit if you’re a risk-averse investor.
- You’re Comfortable With Average Returns. If you believe there’s too much hype on trying to beat the market and you’re better off accepting average market returns, index funds are the way to go.
You Should Invest in Active Mutual Funds If…
Mutual funds are a better fit if:
- You’re a Risk-Tolerant Investor. Active mutual funds come with a higher level of risk as well as the potential to produce higher returns. If you’re comfortable taking on higher risk in an attempt to beat the market, actively managed funds might be your best bet.
- You Have Some Research Skills. Actively managed funds are more expensive but don’t always produce higher returns. You should only invest in these funds if you’re comfortable researching their historic returns and you understand the strategies active mutual funds use.
- You Want to Beat the Market. You’re not going to beat the market with index funds, but doing so is a real possibility with active mutual funds. Just keep in mind that any time there’s potential for outsize returns, there’s also potential for outsize losses.
Both Are Great If…
Both index funds and mutual funds are excellent options if:
- You Want a Mix of Safety and Performance. Index funds and active mutual funds make a great mix if you’re interested in beating the market, but you don’t want to get too aggressive.
- You Want to Keep Fees Reasonable. Although the lowest cost way to invest is through index funds, it’s possible to keep your overall fees reasonable while producing gains that can outpace the market by mixing the two options together.
- You’re Comfortable With Research. It’s important to research historic returns and investment strategies any time you invest in mutual funds. That’s true even if you’re investing in both index funds and active mutual funds.
Index funds and active mutual funds may seem pretty similar, but there are distinct differences between the two that result in different outcomes. Your decision to invest in one or the other should be based on your willingness and ability to research, risk tolerance, and investment objectives.
It’s important to read carefully the prospectus of any fund you’re considering before you invest, regardless of whether it’s an index fund or managed mutual fund. The prospectus will explain the types of investments the fund makes, the types of strategies it employs, the fees you’ll be charged, and what you can expect from your investment.