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Updated on Tuesday, December 11, 2018
The headline of this article is a bit of a misnomer; index funds are actually a type of mutual fund. The real issue, when considering mutual funds, is whether you buy an index fund or a mutual fund that is actively managed.
Let’s start with the basics. We’ll discuss how mutual funds work, the different investment styles you’ll come across, and the differences between index funds and actively managed mutual funds.
What is a mutual fund?
Mutual funds pool the money of a number of investors together in order to invest in a variety of investment vehicles such as stocks, bonds and other types of investments. These funds are run by professional money managers.
A key advantage of a mutual fund is that it allows investors to invest in a more efficient way than making small purchases of individual stocks and bonds. You may have already invested in a mutual fund without realizing it: Mutual funds are often the investment vehicle offered in company-sponsored retirement plans like a 401(k) or a 403(b).
There are mutual funds with a variety of investment styles and objectives. For example, some funds invest in domestic stocks and international stocks. Within these broad classifications, there are a number of investment styles or asset classes to choose from:
- Value stocks tend to trade at a lower price than their indicators (such as earnings, revenues and dividends) would suggest.
- Growth stocks are those that are anticipated to grow at a faster rate than the stock market as a whole.
- Other funds invest in stocks and bonds from both developed non-U.S. countries as well as those in emerging markets.
- Some funds invest in stocks of various size, including large companies such as Apple and Microsoft as well as much smaller stocks.
Beyond this, there are mutual funds that strike a balance between stocks, bond and cash, as well as some that allocate their portfolios based on the investor’s tolerance for risk or their target retirement date.
Mutual funds can be purchased via large brokerage firms like Fidelity, Charles Schwab and Vanguard. Full-service stock brokers also offer access to mutual funds. To purchase a mutual fund, you need to have an account somewhere to house your funds. Costs to purchase can range from free to various levels of transactions fees, so it’s wise to investigate what the typical cost will be before deciding where to trade.
Mutual funds can be beneficial because they offer smaller investors the opportunity to invest in a diversified fashion with professional management for a relatively small amount of money. However, some mutual funds can be very expensive. Investors also have no control over how the portfolio is managed, including when capital gains are distributed, which can be costly at tax time.
What is an index fund?
An index fund is a type of mutual fund that seeks to replicate the holdings of an index such as the S&P 500 or others. There are index funds that track various stock-based indices, bond indices and others.
Index funds are traditionally weighted by “market cap.” This means that the largest stocks or bonds make up a higher percentage of the fund. For example, the top three holdings in the Vanguard 500 Index Fund were Apple, Microsoft and Alphabet (the parent company of Google) at the end of October 2018. When these top-weighted stocks or sectors do well, the fund does well; when they fall in value, their heavy weighting on the fund will cause the fund to decline in value disproportionately.
There are several arguments in favor of index funds. In many cases, index funds have outperformed other mutual funds in their investment category over time. For the period ending November 30, 2018, for example, the popular Vanguard 500 Index Fund’s performance relative to its peers in Morningstar’s large-blend category was in the:
- Top 17% for the trailing three years
- Top 13% for the trailing five years
- Top 27% for the trailing ten years
An advantage of many index funds is that their expenses are lower than their actively managed counterparts. Index funds are passively managed, resulting in lower expenses for research and usually much lower trading costs than actively managed funds. Mutual fund returns are net of expenses, meaning that everything else being equal, a fund with lower expenses starts with an advantage over higher-cost funds.
However, just like anything else, not all index funds are created equal. While a number of fund firms — such as Vanguard, Fidelity and Charles Schwab — offer low cost (or even no-cost) index funds, others carry much higher expenses. It’s important to look beyond the “index fund” label and really understand all aspects and costs of a specific fund before investing.
Index funds can have downsides as well. When an index like the S&P 500 falls into a market correction, funds that follow this will fall just as hard. Index funds can accumulate large positions in stocks that do exceptionally well, but when these stocks decline in value, this can cause a large drop in the value of the fund due to their large presence in the index.
What is an actively managed mutual fund?
The managers of actively managed mutual funds pick specific stocks, bonds or other types of investments for the fund. They use various analytical tools and criteria to select the holdings for the fund in hopes of outperforming the fund’s benchmark.
For example, a fund that invests in large-cap domestic stocks might use the S&P 500 as the benchmark for their fund. A fund that invests in bonds might use the Barclay’s Aggregate Bond Index as its benchmark.
Results for actively managed funds can be quite mixed. Outperforming the financial markets on a consistent basis over time is as hard as it sounds. A fund manager’s strategy may go in and out of step with the markets at any given time.
Other factors that can impact the performance of an actively managed fund include:
- Turnover in the fund’s management. It’s important to check to see if the current managers are the ones who are responsible for the fund’s longer-term track record.
- A fund’s past success. Lucrative funds often attract more investor money. In some cases, it can be difficult for the managers to put all of this new money to work as efficiently as they have in the past.
- How much it costs to run the fund. The cost of active management is higher than passive indexing, therefore the costs of an actively managed fund are usually higher. Those costs eat into your potential earnings.
Many investors opt for actively managed mutual funds because of the potential for index-beating returns. Depending on the fund and the manager’s decisions, you might also benefit from some added protection when the market heads down due to the fund’s active approach.
However, actively managed funds are more expensive to operate than passively managed index funds. In addition, beating an index benchmark consistently is difficult to do. Every system of picking stocks has its flaws, and fund managers are human; emotions and biases can get in the way as well.
Index funds vs. actively managed mutual funds
Mutual funds can be a convenient and sensible way to invest in a wide range of investment types and styles. They can also help smaller investors easily diversify their portfolios.
Index funds and actively managed mutual funds offer choices and options. Before investing, be sure to understand where you are putting your money, the costs and how it will be invested. And remember: It’s not always an either-or decision. Both types of funds can have merits in a portfolio when used together.