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.
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. 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. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
