A common question we always receive is on the main differences between mutual funds and index funds. In this article, we will look at the key similarities and differences between index funds and mutual funds. We will also look at the pros and cons of investing in the two assets.
What is a Mutual Fund?
Mutual funds are very common in the United States. In fact, according to Statista, the total assets under management in all mutual funds in 2019 was more than $17 trillion. With the bull market in 2019, the number has certainly grown significantly. In perspective, the US has a total GDP of more than $20 billion. If the amount invested in mutual funds was a country, it would be the second-biggest after the United States.
While mutual funds are very common, most people don’t know how to explain them. The best way of thinking about a mutual fund is to think of an apartment that is selling at a million dollars. A group of ten people team up and buy the apartment. If they all contribute equally, it means that they will each chuck $100k. After they buy the apartment, it means that they each mutually own the apartment. They will be entitled to any rent that the apartment brings.
A mutual fund works in the same way. The term mutual means: relating to a plan whereby the members of an organization share in the profits and expenses. The same dictionary defines fund as “a sum of money or other resources whose principal or interest is set apart for a specific objective.”
Using these definitions and the previous example, we can now define what a mutual fund is. It is a fund that is formed by a group of people to invest in various assets. As such, a mutual fund that invests in stocks is known as a stocks mutual fund. A fund that invests in bonds is a bond mutual fund. A fund that invests in international stocks is known as an international stocks mutual fund.
What is an Index Fund?
An index fund is an important way to invest in stocks. It is similar to a mutual fund. Still, there is an important difference. An index fund is a type of fund that tracks the performance of an index. Therefore, it is important to understand what an index is.
An index is a financial asset that tracks the performance of assets. For example, the dollar index tracks the performance of the dollar against a basket of peer currencies. Similarly, the Dow Jones Industrial Average (DJIA) is an index that tracks a group of 30 American companies. The S&P 500 is an index that tracks the performance of 500 big American companies. As such, an index does not try to outperform the stock market.
Difference Between Index Funds and Mutual Funds
In the previous two parts, we have defined what an index fund and a mutual fund is. As with the definitions, you can see the main differences. Here are the main differences between mutual funds and index funds:
- Performance. The goal of a mutual fund is to outperform the overall stock market. Index funds don’t aim to outperform the market. Instead, they aim to track their performance.
- Time to invest. An index fund can be bought any time when the market is open. This is not the case with a mutual fund. These funds can only be bought after the market closes.
- Where to buy. Index funds are offered by many brokers, including Robinhood and Charles Schwab. This is not the case with mutual funds, which can only be bought from the mutual funds themselves or from a mutual fund supermarket.
- Costs. Companies that provide mutual funds charge a fee that ranges from 0.5% to 2.5% of assets. Index funds are like stocks and they don’t have these fees.
Similarities Between Mutual Funds and Index Funds
There are two main similarities that exist between mutual funds and index funds.
- Diversification. The biggest similarity is that the two funds are useful for diversification. They all track tens or hundreds of companies.
- Professionally managed. Both index funds and mutual funds are managed by a team of highly-professional people.
Types of Mutual Funds and Index Funds
Another similarity between index funds and mutual funds is that they all have similar types of assets. Here are the most common types of mutual funds and index funds.
- Sectoral funds. These are funds that invest in various sectors of the stock market. These sectors are technology, industrial, financial, and utilities among others.
- Assets funds. There are funds that invest in stocks while others invest in bonds.
- Regional funds. There are mutual funds and index funds that focus on regions. For example, there are American, European, and emerging market funds.
- Types of companies. There are funds that invest in growth, value, and dividend stocks companies.
- Hybrid funds. There are funds that invest in both stocks and bonds.
Biggest Mutual Fund Companies
Mutual funds are provided by large investment companies. There are hundreds of these providers in the United States. Here are the ten biggest mutual fund companies by assets.
- Pacific Investment Management Company (PIMCO). PIMCO has more than $326 billion in mutual funds assets under management.
- Dimensional Funds. The company has mutual funds that are worth more than $375 billion.
- Teachers Insurance and Annuity (TIAA). Total mutual funds assets are more than $423 billion.
- Franklin Templeton Investments. Its mutual funds assets under management are worth more than $432 billion.
- Blackrock. The biggest fund manager in the US has more than $495 billion in assets under management.
- JP Morgan. The biggest bank in the United States has more than $532 billion in mutual funds assets.
- T.RowePrice. It has more than $582 billion in mutual funds assets.
- **American Funds. American Funds has more than $1.6 trillion in mutual funds assets.
- Fidelity Investments. Fidelity has more than $1.9 trillion in mutual fund assets under management.
- Vanguard. Founded by Jack Bogle, Vanguard has more than $3.2 trillion in mutual funds under management.
Investing in index funds and mutual funds is a great way of participating in the financial market. We have always championed investing in these assets for years. We believe that these funds should form part of your retirement portfolios. At the same time, we believe that you should be exposed in individual stocks and commodities. A small portion of your portfolio should be in relatively risky assets like crypto and growth stocks.
Crispus is a finance professional with more than a decade experience in the industry. Over the years, Crispus has written in-depth articles on leading platforms like CCN, Marketwatch, and Seeking Alpha. He also runs a Forex education and managed account company called WestEndFx.