Traditional mutual funds have come under heavy critical fire lately. This has given them an increasingly bad reputation due to their high fees and costs that eat away at overall returns. All this criticism has left investors questioning whether traditional mutual fund investments are good, bad or just plain ugly.

So what should the wary investors – who want to put their money into the market but don’t have the time or energy to conduct adequate market research – do with their money? Sure, traditional mutual funds are one option, but index mutual funds can be a better one. Now, the question may be, what’s the difference between the two?

The answer to that question is plenty. In an effort to prevent eyes from glazing over and minds from wandering, let’s focus on the major differences between the two, which are management philosophies and costs.

The management philosophies of traditional mutual funds versus index mutual funds are polar opposites. Traditional mutual funds operate under an active management philosophy while index funds operate under a passive management philosophy.

Mutual Fund Management Style

“Active management” means the mutual fund manager chooses the securities to buy, sell or hold in the mutual fund’s portfolio. Fund managers thoroughly investigate and research each security, usually through a complex active investment strategy. The main purpose of actively managed mutual funds is to earn higher returns than the market, referred to as “beating the market.”

Of course having someone manage your investments isn’t free. Fees for actively managed funds can take a bite out of your return on investment. So, why do people do it? Well, as they say, you can’t win if you don’t play. Investors for actively managed funds are willing to pay for the possibility of earning more than the market.

On the other hand, “passive management” means there are no fund managers that devise a strategy regarding buy, sell and hold decisions for the fund’s portfolio. The makeup of an index fund portfolio consists of securities listed on a particular index. For example, an S&P 500 index fund will have securities listed on the S&P 500 in its portfolio. Easy as that. No crystal balls, no complicated algorithms or complex investment strategies. Unlike actively managed funds that want to beat the market, the goal of an index fund is to keep pace with market returns.

Passive management doesn’t mean the absence of fund management all together, it simply means less management. Index funds still have fees, they’re just typically much lower than that of actively managed funds.

So what exactly are these fees and what’s it going to cost you?

Costs of Traditional vs. Index Funds

All mutual funds come with fees. One of the most important fees is the operating cost of the fund called the expense ratio. Expense ratios do not include additional fees like sales commissions (called loads) or 12b-1 fees, which is the cost of marketing and advertising the fund. Nor do they include redemption and transfer fees. Here’s the breakdown in traditional mutual funds versus index mutual funds:

Traditional mutual funds have an average expense ratio of between 1% and 1.5%.
They also usually carry 12b-1, redemption and transaction fees. With the exception of no-load funds, you will have to pay a sales commission fee either when you purchase the fund (front-end load) or when you redeem your shares (back-end load).

This means, after you make your initial investment the 12b-1 fee and commissions fee come off the top. Then, the mutual fund company charges you the expense ratio for every year you own the fund.

Index funds have an average expense ratio of between .2% and .25%. Some also charge loads, redemption, transaction and 12b-1 fees, but most of them don’t. The good ones hardly, if ever, charge additional fees outside of the expense ratio.

The point to investing is to make your money work for you right? When it comes to investing in traditional mutual funds versus index mutual funds, think of it this way: There was a certain sports hall-of-famer who once said “…there is no asterisk in baseball.” Well, he may have made it into the hall of fame, but due to his (alleged) behavior, the negative denotation of an asterisk forever taints his record.

Mutual fund returns are the same way. They may earn a return, but those returns must also bear the negative denotation of an asterisk because of their high fees. Keep that in mind when deciding on the best mutual fund investment for you.