Index funds and mutual funds are two popular types of investments for Roth IRAs and other retirement accounts. Both allow you to put your money in hundreds of different stocks, bonds, and other securities with a single investment. An index fund attempts to match the performance of a stock index or the stock market as a whole, while the goal of an actively managed mutual fund is to beat the market.
In this article, we’ll cover the difference between index funds and mutual funds. We’ll explain what to look for in each investment to help you decide which one is best for your Roth IRA.
- Index funds and mutual funds invest in a basket of securities such as stocks or bonds, and are popular investment choices for Roth IRAs.
- An index fund tracks the performance of a benchmark index, while the goal of an actively managed mutual fund is to outperform the benchmark index.
- Passively managed index funds have lower fees and tend to outperform actively managed funds over time.
How Index Funds Work
An index fund is a type of fund that attempts to track the performance of a market index. Although you can’t invest directly in an index, an index fund allows you to invest in the securities it tracks.
An S&P 500 index fund, such as the Vanguard S&P 500 ETF (VOO), invests in the 500 stocks represented in the S&P 500 index. The Invesco QQQ ETF (QQQ) is an index fund that tracks the Nasdaq 100 index, which is made up of the 100 largest non-financial Nasdaq stocks. You can also invest in index funds that focus on bonds from different regions of the globe or commodities.
Most index funds are passively managed, meaning they don’t have human managers who actively select investments. Instead, the goal is to track the performance of the underlying index as closely as possible via algorithms. Because there’s less human management, passively managed index funds usually have lower fees than actively managed mutual funds.
How Mutual Funds Work
A mutual fund is similar to an index fund in that it’s also a basket of securities a company lumps together in a single investment that investors buy shares in. But unlike index funds, mutual funds are often actively managed, meaning human managers decide which securities to invest in. The goal of an actively managed mutual fund is to outperform the benchmark index. For example, a large-cap stock fund may try to beat the performance of the S&P 500 index.
However, active management comes at a cost. Mutual funds tend to have higher fees than index funds because the investment company has to pay for human overhead. As a result, a mutual fund needs to compensate investors for the additional cost.
Suppose a mutual fund aims to outperform the S&P 500 and the S&P 500 gains 10% in a given year. If a mutual fund charges a 2% investment fee, it would need to deliver 12% gains to truly outperform its benchmark.
Index Funds vs. Mutual Funds for Your Roth IRA
A Roth IRA is a type of retirement account. As with other retirement accounts, such as a 401(k), you have to decide how to invest the money in the account. Mutual funds and index funds are both common Roth IRA investment choices.
|Index Funds||Mutual Funds|
|Goal||Match performance of benchmark index||Outperform benchmark index|
Both types of investments can help you achieve portfolio diversification. But for many investors, index funds are the better choices because the fees are typically lower.
An actively managed equity mutual fund had an average expense ratio of 0.71% as of 2020. That means if you invested $10,000, you’d spend $71 on investment fees. By comparison, the average passively managed index equity mutual fund had an expense ratio of 0.06%, which translates to $6 in fees on a $10,000 investment.
That might not sound like a lot, but high fees can seriously diminish your returns over time. Suppose you invested $5,000 per year over a 40-year career, earning 8% annual returns. If you invested that money in a mutual fund charging a 0.71% expense ratio, you’d pay nearly $270,000 in fees. But for an index fund charging a 0.06% expense ratio, you’d pay just $25,000 in fees over 40 years.
You may think that having human oversight justifies the extra cost of an actively managed mutual fund. However, in the past 10 years, more than 80% of actively managed large-cap funds in the U.S. have underperformed the S&P 500 index.
Which Is Better for You?
The higher cost of active versus passive management isn’t worth it for most investors, given the tendency of actively managed funds to underperform. Therefore, an index fund will typically be a better Roth IRA investment.
However, there are some times an actively managed mutual fund may be worth the cost. Active managers can use advanced hedging strategies, such as short selling and buying options. Sometimes, actively managed funds are better choices for those seeking risk management and tax efficiency, particularly for high-net-worth investors. Also, the costs of active management are worth it if the manager has expertise in a specific sector, which may or may not result in better returns.
A Roth IRA gives you unlimited tax-free growth. So you typically want to put your investments with the highest growth potential in your Roth IRA. If you believe an actively managed mutual fund has a good chance of outperforming the market, using Roth IRA money to invest in it might be a better choice. However, unless the mutual fund’s performance can justify the higher costs, sticking with index funds for your Roth IRA will make sense.
Frequently Asked Questions (FAQs
How do I tell if something is an index fund or mutual fund?
U.S. mutual funds typically have the letter “X” at the end of their ticker symbols. However, some mutual funds may be passively managed index funds instead of actively managed funds. To determine whether the fund is actively or passively managed, look at the “principal strategies” section of the investment prospectus.
How does investing in a Roth IRA work?
When you invest in a Roth IRA, you don’t get an upfront tax break, but you get tax-free withdrawals once you’re age 59 ½ and you’ve held the account for five years. Investors choose their own investments for a Roth IRA.
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Vanguard. “Vanguard S&P 500 ETF (VOO).”
Invesco. “Invesco QQQ ETF (QQQ).”
Investor.gov. “Index Funds.”
Investment Company Institute. “ICI Research Perspective: Trends in the Expenses and Fees of Funds, 2020,” Page 2.
S&P Dow Jones Indicies. “SPIVA,” Click on “10 Years.”
Vanguard. “Vanguard Mutual Funds.”