The main difference between index funds and mutual funds is that index funds focus on replicating index performance while mutual funds actively try to outperform the index.
Index funds are exchange-traded products that seek to replicate the economic performance of an underlying index at a minimal cost.
Index funds have gained tremendous popularity in the investing world due to factors such as low-cost structures, vast diversification opportunities and a range of investible asset classes in a passive manner.
In contrast, mutual funds continue to stand alongside index funds to provide investors with a platform to choose asset allocators that manage portfolios actively.
Mutual funds are vehicles to deploy investor capital pools based on the investment mandate and objectives outlined.
As a result, mutual funds are professionally managed and have a higher fee structure to gain advantages by the fund manager’s discretionary decision-making.
| Index Funds | Mutual Funds | |
|---|---|---|
| Purpose | Track Market Returns | Outperform Market Returns |
| Cost | 0.10% or less | 0.50% or more |
| Strategy | Replicate index portfolio passively | Discretionary and Active |
| Leverage | – | Leveraged funds do exist |
| Rebalancing | Consistent rule-based | Optional |
Purpose of Fund
Index funds represent a fundamental building block in long-term investors’ portfolios as they seek to mimic returns of benchmark indices without paying hefty management fees.
This means investors can buy these assets and essentially forget about managing this position if owning equities for the long term is consistent with their investment objectives.
On the other hand, mutual funds come in various types, and they have an underlying theme highlighted in the funds’ investment objectives.
Mutual funds actively try to beat the underlying benchmark for a higher fee and compensation structure.
As a result, if a given mutual fund has a thematic sector exposure such as to financials, this investment will perform in a specific way in different market regimes.
At that point, investors decide whether this sector exposure aligns with their investment goals and can be a source of excess returns.
Costs
Index fund investing revolutionized the personal finance space by offering unmatched long-term returns by charging only a few basis points in fees to investors.
For example, StateStreet’s most popular ETF SPY with $440 billion in assets charges less than 0.10% in fees to match the market returns of the S&P 500.
Mutual funds are significant at providing exposure to specific sectors of the economy.
They have a focused investment allocation style that can outperform the market during specific periods.
However, investors are taking a couple of bets for being underweight/overweight in those sectors relative to the market and the magnitude of excess returns over the fees charged for more active and tactical asset allocation.
Historically, several renowned studies have concluded how the disparity in fees over the long term chips away at mutual funds’ investment performance and produces inferior returns to passive investment vehicles.
Did You Know
Canadians can invest in index funds with as little as $50 each month.
Asset Classes
Index fund investing can be considered boring by some as the fund simply matches the underlying constituents the index is based on.
Index funds are extremely good at what they are designed for, and investors can utilize a broad basket of index ETFs to produce the desired position and express a specific view in the marketplace.
Mutual funds can be more attractive as investors can invest in a multi-strategy fund that invests in equities, fixed income and/or commodities to produce a diverse risk profile and smoothen out returns.
However, mutual funds are governed by their investment mandate, and it’s not a one-size-fits-all for the mutual fund universe.
Leverage
Index funds generally do not use leverage and are tools to replicate market returns as they move in lockstep with their underlying benchmarks.
Mutual funds traditionally haven’t used leverage to enhance returns.
With the rising popularity of online discount brokerages offering commission-free trades, there has been a rise in demand for leveraged products with a more volatile return profile.
Mutual funds now provide leveraged exposure to benchmark indexes but have higher management expense ratios and tracking errors to the underlying.
Rebalancing
Index funds by their given structure often have to adjust portfolios to replicate the index’s components that the fund tracks.
In recent times, the major indices have disproportionate
exposure to high growth technology stocks as they have gained value relative to the other sectors, forcing indexers to rebalance these names in a price-weighted index.
This highlights a unique challenge faced by index investors to buy stocks that have gone up in value and sell stocks that have declined.
As a result, most index flows are allocated to specific sectors and may pose concentration risks in an investor’s portfolio.
Mutual funds similarly seek to benefit from these sector performers by overweighting such sectors and potentially outperforming the markets.
The only difference lies in the fact that investors are actively seeking this exposure, while passive investors might not have intended to get such concentration in their portfolios.
