Index Funds vs. Mutual Funds: Key Differences and How to Choose

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Diversifying your investment portfolio may mean funding mutual funds and exploring index funds. Understanding the difference between index funds and mutual funds will help you decide whether you need both or one over the other. 

Index funds try to match a benchmark index like the S&P 500. They can also hold stocks, bonds, and other assets like mutual funds, but they are passively managed. Because of this passive management, fees tend to be lower.

Mutual funds are likely more familiar to you. These funds are typically composed of stocks, bonds, or assets. They can be professionally or passively managed and typically carry higher fees, but they are better for long-term growth potential.

Index funds try to match market performance, while mutual funds try to outperform the market. Knowing the key differences will help you understand what is right for your portfolio. 

What Are Index Funds?

Knowing the definition and features of index funds will help you decide whether to pursue this investment. Index funds tend to lean more conservative since the returns are predictable. Current data shows that index funds that use the S&P 500 as a benchmark have a historical return of 10%. There is some variability, but over the long term, the S&P 500 performed well.

Definition of Index Funds

There’s no structural difference between a mutual fund and an index fund. An index fund is simply a passively managed mutual fund that tracks a certain index, such as the S&P 500. Let’s look at the key features traditionally associated with an index fund.

Key Features of Index Funds

Key features of index funds make them attractive investments. Some of these features include:

• Low expense ratios. Index funds generally have lower management fees compared to other funds. 
• Diversification through broad market exposure. Investments are based on a wide range of companies within an index, which minimizes risk. 
• Minimal trading activity. Since index funds are managed passively, this typically means low costs, fewer taxes and better long-term returns. 

What Are Mutual Funds?

Familiarizing yourself with mutual funds and the key highlights of this investment can assist you in determining whether this investment is a feasible financial strategy. Many make mutual funds a dominant part of their retirement strategy. Mutual funds offers a straightforward way of diversifying a portfolio without spending hours of research and guessing which investment will make money. Instead, you rely on a professional money manager to decide on what makes a good investment.

Definition of Mutual Funds

A mutual fund is a collection of assets pooled together into a single fund you can invest in. Actively managed mutual funds rely on the expertise and research of individuals who choose how to invest the money. Professional management, high fees and a focus on a specific sector the hallmarks of mutual funds.

Key Features of Mutual Funds

Here are some key features of mutual funds: 

• Professional management. Mutual funds are often managed by a financial firm that is actively trading assets and is equipped with the tools and resources to maximize the potential for returns. 
• High fees. Since active trading is involved, as well as management costs, mutual funds carry higher fees than index funds. 
• Focus can be goal-centric. The mutual funds you choose allow you to focus on specific sectors, asset classes, or investment strategies.

How Do Index Funds and Mutual Funds Compare

A visual comparison of index and mutual funds will help you decide whether to include one or both in your portfolio.

Key Differences Between Index Funds and Mutual Funds

Index and mutual funds differ in their management style, costs and fees, performance expectations and tax efficiency, 

Management Style

Index funds follow a more hands-off management style since they generally follow a certain index. The goal is to match the losses or gains of the index they track. No one picks the investments within the fund. Instead, the fund automatically invests in a representative sample of the stocks and bonds in the index it tracks, so it’s looking to match the market rather than beat it. 

Mutual funds are actively managed because their goal is to outperform the market. The company that runs the mutual fund has a fund manager and researchers making investment decisions. Investors simply buy into the fund and monitor the performance of the stocks the fund manager has selected for inclusion in the mutual fund.

Costs and Fees

Funds are cost-efficient, giving investors access to the broader market without having to invest large sums of cash to buy numerous individual stocks. But you’ll likely pay higher fees if you opt for an actively managed mutual fund over an index fund. 

The fees for an index fund or mutual fund are expressed as an expense ratio. Expense ratios indicate how much of a fund’s assets are spent on expenses such as management and advertising. The percentage is usually higher for actively managed funds because of the cost of employing a full-time manager as well as the cost of executing frequent trades.

In general, index funds are not managed, so there is less overhead and management cost. As a result, index funds have a lower expense ratio than mutual funds. 

Higher costs are associated with mutual fund transactions because you’ll have to pay the people who manage your mutual fund. 

Performance Expectations

Index funds’ performance tends to be more predictable since they are tracked toward a specific index. There is low risk of underperformance since these funds are in the market. 

Mutual funds strive to beat the market, but success varies. Performance depends on the fund’s management, market conditions and overall strategy. Mutual funds are actively managed to outperform the market so they come with greater risk and volatility. 

Tax Efficiency

No matter how they’re managed, most funds are subject to capital gains tax.

But you’ll likely pay more tax with a mutual fund. That’s because capital gains tax is triggered when the fund manager sells stock at a profit. That profit, or gain, gets distributed to investors, who then pay capital gains tax on the distribution. Actively managed funds trade more frequently,  so they usually distribute more taxable gains compared to an index fund. 

Index funds also have an edge because of the size of their trades. Index fund managers often trade small numbers of shares to stay in line with the index they’re tracking. If a large number of investors redeem their shares — i.e., divest — and the fund managers need to sell shares to cover the redemptions, they can sell the pools of stocks purchased at higher prices, which generates less capital gains.

Choosing Between Index Funds and Mutual Funds

Having a strategy, consulting with a financial planner and reflecting on your financial goals can help you determine whether to add an index or mutual fund to your portfolio. 

Consider Your Investment Goals

What do you hope to achieve with your investment goals? If you’re more comfortable with steady growth and predictable returns, an index fund is likely a better fit. If you prefer minimal management and tax efficiency, an index fund will work in your favor. 

With mutual funds, you have to pay higher fees to try to outperform the market. They suit the investor who prefers active management and is fine paying a premium to try to beat the market. Trying to outguess the market is riskier. 

Evaluate Risk Tolerance

Index funds are ideal for conservative investors who don’t want to actively manage their fund and prefer predictable, steady growth. Age and income may be a factor when considering investing in an index fund. 

Mutual funds may cater to risk-takers seeking targeted growth. By design, investors with mutual funds are trying to outperform the market. This is, of course, more risky. If you’re comfortable with the highs and lows of this strategy, mutual funds will work for your risk tolerance. 

Assess Your Budget

With any financial decision, you need to consider your budget. Index funds tend to cost less than mutual funds, but also give an opportunity to grow existing assets. It may feel like a lighter lift to invest in an index fund rather than a mutual fund because of budget constraints. 

If you want expertise and can afford to pay for mutual fund management, the gains may be worth the cost. 

Can You Invest in Both Index Funds and Mutual Funds?

You can invest in both index and mutual funds. This combined approach will allow you to target stability as well as growth potential. You are also including both active and passive strategies in your portfolio. Here is an example of a portfolio that includes both index and mutual funds: 

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