The differences between investment vehicles can be confusing for many investors. For example, exchange traded funds (ETFs) and index funds (a type of mutual fund) can be a source of confusion largely because many investors think these two vehicles essentially represent the same type of product.
The truth is, ETFs and index funds do have many similarities. However, there are differences between the two.
Mutual Funds and How They Relate to Index Funds
Broadly speaking, mutual funds are a basket of securities that are professionally managed by an investment company. In exchange for that management, investors pay a fee to an investment company based on the level of management involved.
Actively managed mutual funds usually cost more than passively managed funds. The aim of an actively managed mutual fund is to “beat” market returns. The aim of a passively managed mutual fund is to “match” market returns as measured by indexes.
Bearing those definitions of actively and passively managed mutual funds in mind, index funds are, typically, passively managed mutual funds.
Examples: Mutual Funds with Index Benchmarks vs. Index Funds Based on Indexes
There’s a difference between mutual funds with index benchmarks and index mutual funds. For example, an actively managed mutual fund with an S&P 500 Index benchmark would typically include stocks from that index that your investment company specifically selected based on anticipated outperformance. Investors pay for the increased research and investment expertise required to make these stock-selection decisions.
On the other hand, an index fund based on the S&P 500 Index simply seeks to replicate the index, with no estimates regarding anticipated performance. Such funds cost less to operate, so investors generally pay smaller fees, which is where the benefit lies. Passive investors believe that trying to beat the market is so inherently difficult that matching market returns and saving on fees will ultimately create better overall results.
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