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How Do Index Funds Differ From Mutual Funds?

Differentiating index funds from mutual funds is quite complicated since both are very closely related, even quite similar. Index funds are actually a type of mutual funds--they are collectively accumulated from a group of investors who all have a share on the investment returns.

The best way then to differentiate index funds from mutual funds is to see the latter as an encompassing category under which the former can be classified. After all, one cannot presume to say the same thing otherwise; while it is terminologically correct to say an index fund is a type of mutual fund, we cannot define mutual funds with the qualities, principles and investment system of index funds.

Index Funds

An index is a type of passive investment management wherein human factor is almost completely disregarded. There may be a board or core group of investors who oversee the movement of the funds, but the selection of the industry or market where the money will be invested in is purely random; sometimes the selection process is even electronic.

As a passive investment scheme, an index doesn't particularly need an investment manager who will purchase and sell stocks in order to catch up with the rest of the stock market. It will instead imitate the movement of the stocks of another index (either passively managed or actively managed). It can also choose to keep its trend constant despite of the actual movements in the stock market.

Mutual Funds

When compared with the former, it is usually assumed that we refer to actively managed mutual funds. With this in comparison there are so many points of differences that can be spotted.

Like the index funds, mutual funds are also a pool of money contributed by investors. These funds are then entered into investment ventures in stocks and securities. This is likely where the similarity between the two ends.

As active investments, these funds have appointed investment managers who take charge in the selling and buying of stocks in the stock market. They are charged with the responsibility of determining and predicting trends, and evaluating what will be the most profitable investment move next. It is the goal of mutual funds to at least be up to par with the performance of other indexes. Most preferably, its investors would want to completely beat the stock market and generate large investment returns.

The downside about these funds is that they come with large taxes and management fees, as previously hinted at. Since it employs a management team, investors have to allocate funding for them--and this usually constitutes the largest investment returns cut.

Another income-reducing factor is turnover. The turnover rate for mutual funds is higher than the index funds. A transaction fee is imposed for each turnover, as well as additional tax obligations. It therefore costs active mutual funds a lot of money.

Concluding Comparisons

According to analysts and various studies on the stock market, index funds have higher success rates than mutual funds. They often yield higher returns, mostly because they have lower tax rates and zero investment management fees.