Three main things distinguish an index fund from an actively managed mutual fund: who — or what — decides which investments the fund holds, the fund’s investment objective and how much investors pay in fees to own it.
But perhaps the biggest difference between these two distinct categories of mutual funds is this: If given the choice, investors have a better shot at achieving higher returns with an index fund. Exploring the differences reveals why.
Quick glance: Index fund vs. mutual fund
|Index fund||Mutual fund|
|Investment objective||Match the investment returns of a benchmark stock market index (e.g. the S&P 500)||Beat the investment returns of a related benchmark index|
|Invests in||Stocks, bonds and other securities||Stocks, bonds and other securities|
|Management style||Passive. Investment mix is automated to match the exact holdings of the benchmark index||Active. Stock pickers (fund managers/analysts) choose fund holdings|
|Average management fee (expense ratio)*||0.09%||0.82%|
|After-fee return of $1,000 annual investment earning 7% average annual return over 30 years||$99,000||$86,000|
|Amount lost in fees over 30 years||$1,800||$15,000|
*Source: Asset-weighted averages from 2016 data from the Investment Company Institute
Passive vs. active management
Managing a mutual fund requires making daily (sometimes hourly) investment decisions. One of the differences between index and regular mutual funds is who’s behind the curtain calling the shots.
There’s no need for active human oversight to determine which investments to buy and sell within an index mutual fund. The fund’s holdings are automated to track an index — such as the Standard & Poor’s 500 — so if a stock is in the index, it will be in the fund, too.
Because no one is actively managing the portfolio — performance is simply based on price movements of the individual stocks in the index and not someone trading in and out of stocks — index investing is considered a passive investing strategy.
In an actively managed mutual fund, a fund manager or management team makes all the investment decisions. They are free to shop for investments for the fund across multiple indexes and within various investment types — as long as what they pick adheres to the fund’s stated charter. They choose which stocks and how many shares to purchase or punt from the portfolio. And here’s where the trouble starts for actively managed mutual funds.
History has shown that it’s extremely difficult to beat the passive market returns consistently year in and year out.
History has shown that it’s extremely difficult to beat passive market returns (a.k.a. indexes) year in and year out. In fact, for the 15 years ending in December 2016, more than 90% of U.S. large-cap, mid-cap and small-cap funds helmed by managers did worse than the S&P 500, according to S&P Dow Indices data.
If you can’t beat ‘em, join ‘em. That’s essentially what index investors are doing.
An index fund’s sole investment objective is to mirror the performance of the underlying benchmark index. When the S&P 500 zigs or zags, so does an S&P 500 index mutual fund.
The investment objective of an actively managed mutual fund is to outperform market averages — to earn higher returns by having experts strategically pick investments they believe will boost overall performance.
Potential outperformance of the index is the reason an investor would choose an actively managed fund over an index fund. But you pay a higher price for the manager’s expertise, which leads us to the next — and most critical — difference between index funds and actively managed mutual funds.
The biggest difference to investors: Cost
As you can imagine, it costs more to have people running the show. There are investment manager salaries, bonuses, employee benefits, office space and the cost of marketing materials to attract more investors to the mutual fund.
Who pays those costs? You, the shareholder. They’re bundled into a fee that’s called the mutual fund expense ratio.
And herein lies one of the investing world’s biggest Catch-22s: Investors pay more to own shares of actively managed mutual funds, hoping they perform better than index funds. But the higher fees investors pay cut directly into the returns they receive from the fund, leading the majority of actively managed mutual funds to underperform.
Index funds have become known and celebrated for their low investment costs.
Index funds cost money to run, too — but a lot less when you take those full-time Wall Street salaries out of the equation. That’s why index funds — and their bite-sized counterparts, exchange-traded funds (ETFs) — have become known and celebrated for their low investment costs compared with actively managed funds.
But the sting of fees doesn’t end with the expense ratio. Because it’s deducted directly from an investor’s annual returns, that leaves less money in the account to compound and grow over time. It’s a fee double-whammy and the price can run high. (We calculated that a 1% fee difference could cost a millennial more than half a million dollars over time.)
The bottom line: The lower the management costs, the higher the investment returns for shareholders.