What is the difference between index funds and mutual funds? As a beginner investor one might have only heard of mutual funds. Jack Bogle and Vanguard has popularized the concept of index funds in recent years and I think has changed the way many people choose to invest their money.
People are smarter about their money now and access to information online is much easier- so you can educate yourself about the difference between index and mutual funds, and figure out the fees associated with each investment more easily.
What Are Index Funds
Index Funds can either be index funds or ETFs (exchange traded funds) and the aim for index funds is to track and follow an index, like the most famous index out there, the S&P500.
The stocks and bonds and investments within an index fund try to correlate very closely with what is made up of an index. The aim of an index fund is not to ‘beat the market’ but to simply ‘match the market’. The MER (management expense ratio) of index funds and exchange traded funds are typically very low (like usually under 0.20%). They are low because they are not actively managed. There is no buying and selling and analyzing to try and beat the market.
When the fees associated with investing are low, that means you get to keep more money in your portfolio (which is a great thing). Additionally, index funds allow you to ‘set it and forget it’ (provided you do some rebalancing of your overall asset allocation- and make sure you’re not suffering from Canadian home bias).
One example of an index fund is the TD e-series index fund. It gives the flexibility of dollar cost averaging and pre-authorized purchases like a typical mutual fund without the extra cost. I am a fan, and we have our baby’s RESP with some TD e-series funds.
What Are Mutual Funds
Mutual funds are also composed of stocks and bonds and other investments, but the goal of a mutual fund is to try and beat the index.
Mutual funds are managed by a mutual fund manager. This mutual fund manager is paid top dollar (by your investment) to analyze and invest in securities that he or she thinks will beat the index. There is a lot of buying and selling within a mutual fund.
Since the mutual fund manager is paid top dollar, the management expense ratio of mutual funds are usually high. In Canada there are also other fees that make up the MER, such as trailer fees and taxes according to IFIC.ca. Trailer fees are banned in Britain and Australia, but not in Canada and it was quite a heated topic in recent years.
What’s the Difference between Index Funds and Mutual Funds?
The basic difference between index funds and mutual funds are that index funds are passively managed and mutual funds are actively managed. By passive management I mean there’s no buying and selling of stocks within the index fund or ETF. By active management I mean that there’s a lot of activity, buying and selling of securities within the mutual fund.
Here are some other differences between the two:
- Higher cost for mutual funds compared to index funds
- You need to rebalance index funds unless you have one that automatically rebalances like VGRO
- Mutual funds are purchased by NAV (net asset value) per share (total value of all securities in fund / # outstanding shares)
- Mutual funds are usually the first investment that you might start off with just because they are so heavily marketed
- Mutual funds are probably more flexible in terms of dollar cost averaging (unless you have a no fee ETF buying brokerage)
- There could be the potential for higher returns with mutual funds (for example Peter Lynch is a well known mutual fund manager who beat the street with his Fidelity Magellan fund).
Active vs Passive Management: Which One Performs Better?
According to The Globe and Mail the statistics are stacked against active management with mutual funds and fund managers:
The most recent Standard & Poor’s SPIVA Canada Scorecard, released last month, shows mutual fund performance after all fees and costs, up to the end of June. In the Canadian equity category, 32 per cent of active funds beat the S&P/TSX composite total return index over the past three years. About 20 per cent beat the index over the past five years.
Warren Buffett, the best investor of all time, time and again says that index investing is the best way to grow wealth.
Which one is Better for the Beginner Investor?
As a beginner investor, my first investment was a mutual fund. I can’t remember which one but I think I spoke to a mutual fund salesperson that my mom knew. It was one of the beginning stages of my investing journey. I also invested with Investor’s Group (notorious for their super high MER fees) as well because I didn’t know any better.
I was really disappointed that they weren’t calling me once a year to update me about my investments and was disappointed to see that my investments were dropping and I was actually losing money (it wasn’t during a down period, I’m not sure what really happened). Now I know better and DIY invest and hold Power Corporation of Canada in my portfolio (who owns Investors Group) and don’t have any mutual funds at all.
Since mutual funds are actively managed and the fees associated with mutual funds are typically over 2%, this can very much so erode your wealth over time. 2-2.5% doesn’t seem like a lot, but when you’re up 7% annually, and you subtract 2.5% that’s only 4.5% return.
To see how a mutual fund fee impacts your investment portfolio, you can check out this mutual fund fee calculator from Getsmarteraboutmoney.ca. This calculator lists all the mutual funds available in Canada. For example, the TD Asset Management Aggressive Growth Portfolio had a past annual return of 5.47% and a management fee of 2.27%.
To save money you could use a DIY brokerage like Questrade and use a free service like Passiv to tell you what to buy to rebalance your investments. It’s free for the first year for Questrade users.
Do you favour index funds or do you favour mutual funds?
Was a mutual fund your first investment encounter or experience?
GYM is a 40 something millennial writing about personal finance since 2009 and interested in achieving financial freedom through disciplined saving, dividend and ETF investing, and living a minimalist lifestyle. Before you go, check out my recommendations page of financial tools I use to save and invest money. Don’t forget to subscribe for a free dividend yield spreadsheet and the free Young Money Bootcamp PDF.