Beat the market or mirror it?
In short:
To be clear, an index fund is a type of mutual fund or exchange-traded fund (ETF) whose stated investment objective is to track and mirror the performance of a certain index. Generally, when people ask the question “index fund vs mutual fund, which is better?” they are referring to an index fund (passively managed) vs an actively managed mutual fund.
When comparing an index fund to an actively managed mutual fund there are two main differences an investor will find. The first is the investment strategy. Actively managed mutual funds have an investment strategy with an objective to beat a certain index through active buying and selling of the underlying securities that make up the fund’s portfolio. Index funds employ an investment strategy of matching the performance of an index by constructing a portfolio that looks like the index itself.
The second is the cost associated with each type of fund called the expense ratio. Since index funds require less work to manage, they are usually much cheaper for the investor. Actively managed mutual funds require more work since they are continuously looking for additional investments resulting in higher fees.
Key Points
- Index funds are mutual funds or ETFs whose aim is to mirror the performance of a stated index.
- Actively managed mutual funds aim to beat the performance of an index.
- Index funds typically have very low costs to invest in since they are passively managed.
In-depth:
How index funds work
Introduced in the 1970s, index funds were quite a change for the mutual fund industry. Instead of investors putting their money in an actively managed mutual fund whose goal was to beat a stock market index. Investors would simply invest in a mutual fund whose objective is to mirror the index as if they were buying it themselves.
When an investor puts money into an index fund, they are essentially buying a very small portion of each stock within that index. For example, if an investor was to invest $100 into a fund that tracks the S&P 500 that investor would, in a sense, be buying $5.54 worth of Apple stock, $5.40 of Microsoft stock, and so on all the way to $.04 of whirlpool stock.
This is because the S&P 500 index is based on a market-cap-weighted methodology. So the amount of influence a company has in this index is determined by the size of the company. The larger the company the more it makes up the index which is why we see the investor $100 goes more toward Apple (the largest company) and less toward whirlpool (one of the smaller companies).
When a fund is constructed to be an index fund it makes managing the fund much easier. This is because the fund manager only needs to rebalance the underlying fund portfolio if and when the index changes. This also results in generally lower turnover (buying and selling) think buy and hold.
Types of indexes
While it may be easy to write index funds off as a quick way to a diversified and boring portfolio that will slowly move along and only track an index such as the S&P 500, making such an assumption would be unsound. There are thousands of indexes for nearly every financial market and market segment that an investor may want to focus their participation on. Here are just some of the most popular indexes:
- Standard & Poor’s 500 is a market-cap-weighted index of the largest 500 companies in the United States. This is the index which is often referred to as “the market”. See here: S&P 500.
- Dow Jones Industrial Average is the second oldest US stock market index which tracks 30 large public companies. This index uses a methodology which factors in a company’s stock price and the need for the Dow Divisor. See here: DJIA.
- Nasdaq Composite is a market-cap-weighted index which tracks over 2,500 companies that trade on the Nasdaq -a US stock exchange which the likes of Microsoft and Facebook trade on. See here: Nasdaq Composite.
- Nasdaq 100 an index of the largest 100 companies which trade on the Nasdaq. Uses a modified market-cap weighting system.
- Russell 2000 index composed of 2,000 smaller mostly US companies which many of the large indexes do not cover. See here: Russell 2000.
How actively managed mutual funds work
A mutual fund is an investment vehicle which pools money together from many investors in order to implement an investment strategy which could include buying stocks, bonds, or other assets. Mutual funds give investors access to professional money managers who allocate the funds money on behalf of their investors, often giving investors access to better diversification (reduced risk) than they could have on their own.
Mutual funds aim to make money for their investors from the increase in value of the securities they invest in. Each investor thereby participates in the gains or losses of the overall portfolio of the fund in proportion to their investment.
Actively managed funds are funds where the money manager is actively looking for companies to bring into the portfolio or throw out of the portfolio. The idea here is that the money manager and their team will be able to identify companies that will help the fund outperform passively managed funds. As a result, these funds are typically more expensive to own as they have to hire more analysts and incur more trading fees. On top of that, there is no clear history of these funds performing better than passively managed funds on a broad basis.
Types of mutual funds
While we cover the different types of mutual funds with great depth in our extensive article on mutual funds here is a high-level overview of some of the different categories mutual funds may focus on:
- Equity Funds (stocks) these funds primarily focus their investment on stocks. The vast majority of all mutual funds are equity funds. The reason for this is also the main reason mutual funds came about, diversification in higher returning yet riskier assets such as stocks.
- Bond Funds (fixed-income) the goal of these funds are to provide their investors with consistent regular cash dividends. Traditionally these funds have been recommended to people in retirement who rely on the investment dividends to live off of. Inflationary periods may prove challenging for investors in these funds.
- Global Funds the funds in this category focus on investing outside of their home country. If an investor thinks a certain country’s economy looks promising from an investment perspective this may be a way for them to invest in the country. They can both enjoy the benefits of diversified exposure in the country and a professional money manager with better access to information than themselves.
- Specialty Funds many funds that do not belong to any fixed form classification fall within this category. Say an investor is really interested in the green energy space, more specifically, electric car charging. A specialty fund which specializes in this may allow an investor an easier safer way to participate in this segment.
Advantages
Both index funds and actively managed mutual funds have their beneficial place in an investor’s portfolio. The real difference lies in the investor’s objectives, risk tolerance, and the amount of time they want to dedicate to research and monitoring. Here are the respective advantages for both:
Of index funds
For someone looking to take a very passive approach to investing, index funds are an attractive option. Not only are index funds cheaper with expense ratios typically below .5% but they are easier to identify and monitor. Knowing your index fund should perform in line with the market or an index alleviates the risk that the fund manager makes a costly mistake.
Of actively managed mutual funds
For someone looking to take a more involved role in their investments an actively managed fund may be a good option. The challenge here will be finding a fund that has consistently outperformed the market. Additionally, as funds get larger it gets harder for the fund manager to identify either enough opportunities or large enough opportunities to deploy the capital.
That said, with enough investigation, an enterprising investor may be able to identify an actively managed mutual fund which has had great success. In this case, the investor leaves open the possibility to do better than the market. These funds do exist Fidelity Magellan Fund is a good example of one.
Disadvantages
Both index funds and actively managed mutual funds have disadvantages too. Here are a few that belong to each respectively.
Of index funds
The largest drawback to index funds comes with the fact that by investing in an index fund an investor is admitting they aren’t trying to beat the market. Rather, the investor is okay with just performing averagely.
While this is probably the best route for many investors. It is no secret that weighting an investment portfolio with great companies can have a tremendous net positive to an investor’s portfolio this is often thrown out when considering index funds. Instead, index funds are often referenced as the only thing to invest in.
For example, owning Apple, Microsoft, Amazon, or Facebook would have made a huge net positive impact on an investor’s portfolio even if they invested in a couple of lower-performing companies as well.
Of actively managed mutual funds
The biggest drawback with actively managed mutual funds are that typically they are more expensive with expense ratios ranging from .5% to 1% or higher and many of them do not perform to justify the cost of owning. Either the fund underperforms a standard index and is more expensive to own or the fund performs slightly better but is equal after the added expense.
Conclusion – Which is better?
For many to most investors, they will likely find better results with an index fund than an actively managed mutual fund. This only changes relative to the amount of time, energy, and effort an investor is willing to put in without any guarantee of better success.
Frequently Asked Questions
Index funds are a type of mutual fund whose objective is to build a portfolio of underlying stocks that reflect and mirror the performance of an index. Mutual funds are just an investment vehicle that pools money together from multiple investors.
The majority of index funds often outperform actively managed mutual funds.
Index funds are a type of mutual fund whose objective is to build a portfolio of underlying stocks that reflect and mirror the performance of an index. Mutual funds are just an investment vehicle that pools money together from multiple investors.
The S&P 500 is a market-cap-weighted index of the largest 500 companies in the United States. This is the index which is often referred to as “the market”. You cannot actually invest directly into the index as it’s just a mathematical representation.