There is a bit of a debate among many investors as to whether index funds or actively managed mutual funds are the better choice. There really isn’t a right or wrong answer — it just depends on your financial goal. Both have the potential to provide dividends, capital gains payouts, or increased market price.
Here is a look at both types of funds — including a comparison of how they work and their pros and cons — to help you decide for yourself which is the better fund for you.
Index funds vs. mutual funds
|Index funds||Mutual funds|
|Objective||Index mutual funds and exchange-traded funds attempt to replicate the performance of a stock or bond index.||Actively managed mutual funds seek to outperform an index or other funds in the mutual fund’s peer group.|
|Assets||Index funds hold stocks, bonds, commodities or other types of securities depending upon the index the fund is tracking.||Actively managed mutual funds may invest in stocks, bonds, commodities, or other types of securities based on the fund’s stated objective.|
|Management style||Index mutual funds and ETFs are passively managed in an attempt to replicate the index fund’s underlying index.||The managers of actively managed mutual funds make decisions as to which securities to own and not own. These funds tend to make more frequent transactions than their index fund counterparts.|
|Expense ratio||On average, the expense ratios of index funds are lower than those of actively managed mutual funds.
Average of .13% for passive funds
|Expense ratios tend to be higher on average than for index funds. This is due in part to more frequent trading activity.
Average of .66% for active funds
What is an index fund?
An index fund is a mutual fund or ETF that seeks to replicate the performance of a stock or bond market index. This is also sometimes referred to as indexing. Examples are funds that seek to track the popular S&P 500 index or the Russell 2000 index (an index of small-cap stocks).
The manager of the index fund will buy and sell holdings in the fund at predetermined intervals to match the holdings in the index as closely as possible. This could happen as frequently as daily. The replication process will vary a bit from index fund to index fund.
What is a mutual fund?
In this context, we are referring to mutual funds as those funds that are actively managed. In contrast to the way an index fund seeks to replicate the holdings and performance of an index like the S&P 500, the manager of an actively managed mutual fund makes their own investment decisions as to the stocks, bonds, or other securities the fund will own.
Key differences between an index fund and a mutual fund
The manager of an index mutual fund or ETF does their best to replicate the performance of the index. Conversely, mutual funds with active managers generally seek to outperform a specific index that is tied to their fund’s investment objectives.
The difference in management style between index funds versus mutual funds comes down to active versus passive investing.
The management style of an index mutual fund or ETF is passive. This means the managers do not make decisions as to which securities to hold in the fund. Instead, they passively adhere to an investing strategy of replicating the securities that make up the index as closely as possible.
The management of an actively managed mutual fund is just that, active. This means the fund manager will make their own decisions to buy and sell individual stocks, bonds, or other securities that align with the funds objective.
One of the advantages of index funds over actively managed mutual funds are the generally lower expense ratios. This cost advantage largely arises from an index fund’s passive style. Trades are made by an index fund manager, but the trades are made only to bring the index fund’s portfolio back in line with the holdings of the underlying stock or bond index whose performance the index fund is trying to replicate.
The manager of an actively managed mutual fund is likely to do more trading to try to outperform the benchmark stock or bond index the fund is trying to beat.
In its most recent study of fund expense ratios, the financial services firm Morningstar found:
- The asset-weighted average expense ratio of all open-end U.S. ETFs and mutual funds was .45% as of 2019 (this includes both actively and passively managed funds). They note this is down from .87% in 1999. Asset-weighted fees give a higher weighting to the fees charged by larger funds as measured by the assets invested in the fund. Open-end mutual funds are those that issue an unlimited number of shares that investors can purchase from the fund company or via a broker like Fidelity or Schwab.
- The asset-weighted average expense ratio for active funds was .66% and the average for passively managed index funds and ETFs was .13%.
- Their study also looked at the average cost of mutual funds and ETFs on an average equal-weighted basis. This gives more of a true average of all funds in its universe regardless of the fund or ETFs size in terms of assets in the fund. It found that the average fees for an actively managed fund was 1.08% as compared to .61% for passive index funds and ETFs.
Should you invest in an index fund or active mutual fund?
Index mutual funds and ETFs have a number of advantages for investors. As discussed above, index funds and ETFs tend to have lower fees and expenses than mutual funds with active management. All else being equal, lower costs will tend to increase returns. When reporting their returns, mutual funds report these returns net of fees and expenses. So the lower the fund’s expenses, the less of a drag they are on the fund’s net returns.
Another advantage of an index fund or ETF is that they tend to adhere closely to their investment style. As an example, an index fund that tracks the S&P 500 will not stray from its mandate and will closely track the index. The advantage here is for an investor’s asset allocation. They don’t have to worry about the fund straying from its stated investment style, which can complicate the asset allocation process for an investor.
The main advantage of an actively managed mutual fund lies with the manager’s ability to outperform its benchmark index or other funds with a similar objective. As an investor you need to understand how the manager’s investment process works, how they’ve performed in various types of markets, and how they have performed compared with other funds in their peer group. A peer group might be large-cap blend funds or perhaps small-cap growth mutual funds.
When you invest in an actively managed mutual fund you are investing in the manager(s) of the fund and the fund’s investment process. Actively managed mutual funds need to be monitored to ensure the reasons you bought the fund remain intact.
Do you have to pick one or the other?
You absolutely do not have to stick to one type of investing or the other. In fact, it is very common for investors to have a mix of index mutual funds and ETFs along with actively managed funds in their portfolio. These choices could be smart ways to diversify your portfolio, and diversification can help in times of volatility especially.
For example, maybe you want to have a total stock market index fund as a core holding and then add several actively managed mutual funds around that core. Or perhaps you want to focus primarily on index funds but add a few actively managed funds you have researched and think can add value to your portfolio over time.
Which is better: index fund or mutual fund?
The better option between an index fund or an actively managed mutual fund will vary with each investor’s objectives, risk tolerance, and other factors. This choice is not an either-or decision. It is OK to invest in both types of funds within your portfolio. It is better to evaluate on a fund by fund basis, comparing any financial product against your personal investment goals to determine what will be a good fit for your portfolio.
Can you lose money in an index fund?
Investing in an index fund isn’t a guarantee you won’t lose money. If the index that the fund is trying to replicate declines in value, the value of your index fund will decline as well. For example, in 2018 the Vanguard S&P 500 ETF (VOO) declined 4.5% for the year on a total return basis, roughly tracking the index total return for the year. During the financial crisis of 2008, the index lost over 30% for the year and index funds tracking the S&P 500 lost a sizable amount. As with any investment, returns are never guaranteed.
Is it a bad time to buy index funds?
For long-term investors there is no good or bad time to buy index funds. Some may feel that index funds have had a good run in some asset classes and their time has passed. This may or may not be true. Even if it is, this is more of an issue for those who are short-term traders who try to predict the direction of stocks or the markets as a whole. It might be wise to seek investment advice from a financial advisor if you’re struggling to determine whether index funds are a smart fit for your portfolio.
Index mutual funds and ETFs have become a popular investing choice among many people due to their low cost and the fact that many index funds have outperformed many of their actively managed mutual fund peers.
When it comes to how to invest money, actively managed mutual funds can be a solid choice as well, but choosing the right fund and monitoring your choices can be a bit more work.
Neither type of fund is right or wrong and it's likely you have access to both through your brokerage, IRA, or investing app. Which is the smarter way to go depends on your situation as an investor. Using both types of funds in a portfolio is common and could be the choice for you.
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