It’s not uncommon to see beginning investors dip their toes in a pool of investments known as mutual funds. Mutual funds can be categorized by what they invest in, such as money markets, bonds, stocks or target-date funds.
Funds also can be categorized by the investment style used to choose those investments. This covers both index funds and mutual funds. Understanding the difference between these two funds and investment styles can help investors choose the right funds for their portfolios.
What Is an Index Fund?
There’s no structural difference between a mutual fund and an index fund. An index fund is simply a particular type of mutual fund. The difference between mutual funds and index funds is the investing strategy each represents.
Index funds are structured to match the losses or gains of a particular index. 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, if you have an S&P 500 index fund, that fund should increase or decrease in value by the same amount as the S&P 500 every day. This is because the fund owns stocks that are on that index.
What Is a Mutual Fund?
A mutual fund is a collection of assets pooled together into a single fund that you can invest in. Actively managed mutual funds rely on the expertise and research of individuals who choose how to invest the money.
The company that runs the mutual fund has a fund manager and a team of researchers making all the investment decisions. Customers simply buy into the fund and either see their investments go up or down, depending on the fund’s performance.
The fund manager’s goal is to outperform the market. However, there’s always a risk that the fund will underperform the market.
Index Fund vs. Mutual Fund
If you’re choosing between index funds and mutual funds, you’ll want to consider a few factors. Here’s more on how they compare.
Since index funds are a type of mutual fund, you’ll notice a few features they have in common:
- Good options for retirement: Both index funds and mutual funds are popular choices for retirement investing because of their relative safety and consistency, at least compared to individual stocks. They utilize the same financial structures and serve a similar purpose in investors’ portfolios.
- Less risky than stocks: Each type of fund adds diversification to portfolios — an important factor for investors. Funds are also cost-efficient, giving investors access to the broader market without having to put up large sums of cash to buy numerous individual stocks.
- Expense ratios: Both index funds and mutual funds have expense ratios that indicate how much of a fund’s assets are spent on expenses such as management and advertising.
- Fees: Be prepared to pay an annual fee and other expenses with most mutual funds and index funds.
Understanding the key differences between index funds and mutual funds can help you decide which type of fund is right for your portfolio.
- Different priorities: Index funds aim to get the same return as a specific market index. Mutual fund managers try to outperform the market and preserve capital.
- Performance limitations: Index funds might outperform actively managed mutual funds but can never outperform the indexes they are tied to.
- Different expense ratios: As a general rule, index funds come with lower ratios because they are not actively managed by fund employees. For example, Vanguard’s Large-Cap Index Admiral Shares index fund has an expense ratio of 0.05%. In contrast, its Selected Value mutual fund has an expense ratio of 0.33%.
- Passive vs. active management: With index funds, stocks and bonds are chosen because they are part of the tracked index and don’t need active management. Mutual funds are actively managed, meaning the fund manager chooses stocks that are expected to grow.
Ideally, look for mutual funds that have a track record of producing positive returns. While not a guarantee of a fund’s future performance, the track record is a helpful metric. Look at the fund’s performance over a five- or 10-year period to see how much it has returned to investors.
Index Fund vs. Actively Managed Fund
An actively managed fund is one that has a manager or team of managers choosing the investments. By definition, an index fund is the opposite of an actively managed fund because it simply tracks the performance of a specific index.
Do Index Funds Outperform Mutual Funds?
It’s hard to argue with the cold, hard fact that index funds tend to offer the same — or better — performances than mutual funds, and at a fraction of the cost. That should be especially good news to the casual investor.
Over a five-year period, nearly 78% of large-cap funds underperformed the S&P 500. This isn’t a new trend. More than 87% of managed funds underperformed the S&P Composite 1500 between 2005 and 2020.
At the end of the day, the data shows that someone who knows almost nothing about investing can routinely get about the same or better returns with index funds as mutual fund managers with MBAs.
Which Is Better: Mutual Funds or Index Funds?
Index funds and mutual funds can both be excellent options for investing, especially if you’re a retirement investor looking for a simple way to make safe investments.
A closer look at the costs offers a pretty compelling argument for passively managed funds. The difference between 0.2% and 0.5% might not seem like much. But it can add up to hundreds of thousands of dollars by the time you retire.
This is not to say there’s no reason to buy a mutual fund. In plenty of situations, actively managed mutual funds are a better investment despite their higher fees — especially those that consistently outperform the major indexes. Always examine each investment decision in the context of your portfolio and your financial goals.
For example, your specific circumstances might call for a particular fund. If you’re looking for a way to grow your money quickly, keep an eye on aggressive mutual funds with a proven track record of beating the market by high percentages.
Index Funds vs. Mutual Funds: Which One Is Right for You?
If you’re interested in taking an active approach to investing, mutual funds are the better choice. But if you are fairly new to investing, consider low-cost index funds that track major indices like the S&P 500, Dow Jones or Nasdaq. It’s an easy way to make a solid investment that will help you grow your wealth.
Information is accurate as of Feb. 12, 2021.
This article has been updated with additional reporting since its original publication.