Picking stocks can be exhausting, especially when you don’t have the same access as market pros. So why not let the professionals do it for you? That’s the idea behind mutual funds, which allow investors to buy a package of assets through a single wrapper. At the opposite end of the spectrum are index funds, which also function as stock baskets but don’t employ the services of a manager.
What are the differences between the two types of funds, and which is better for you? Read on for our complete breakdown between mutual funds and index funds.
Mutual vs. Index Funds Comparison Chart
Take a look at the chart below for a side-by-side comparison between the two types of funds.
|
|
Mutual Funds |
Index Funds |
|
Fees |
High expense rates, plus potential load and redemption fees |
Lower expense rates, fewer fees |
|
Risk / Return |
Riskier / Seek to outperform the market |
Less risky / Seek to match market return but may underperform top mutual funds |
|
Management Style |
Active |
Passive |
|
Minimum Investment Amount |
Between $1 to $3,000 |
Between $1 to $3,000 |
Differences Between Mutual and Index Funds
When choosing between mutual funds and index funds, it's important to know the differences. Before you make an investment, here are five features to consider.
1. Management Style
Names like Peter Lynch, Jim Simons and George Soros come to mind when discussing the best fund managers ever. When you invest in a mutual fund, you’re not so much picking stocks or a strategy but selecting a manager who you think can beat market averages.
With an index fund, you aren’t trying to beat the market. That’s not to say you aren’t interested in making money, but index funds aren’t concerned with outperforming the competition. Index funds track benchmarks like the S&P 500, so no manager selects stocks. The fund aims to match the benchmark as closely as possible while driving down costs that come with active trading, whether by using a broad index or a targeted one like a specific stock sector.
2. Fees and Expenses
Investment companies manage mutual and index funds, and their overhead costs are baked into the price of an investment. For most investors, this comes in the form of an expense rate, the percentage of invested assets that goes to the fund company for the costs of running the fund.
A study from the Investment Company Institute showed that mutual fund costs have been falling for nearly 30 years, which is excellent news for investors. However, the difference in cost between mutual and index funds remains vast. In 2023, the median expense rate for equity mutual funds was 1.01, and the average was 1.11. Those expenses dropped to 0.25 and 0.55 for equity index funds, respectively.
3. Performance
The reason to invest in mutual funds is to outperform the market benchmarks — otherwise, why pay the higher rates for a fund manager? Some managers, like Peter Lynch and the Magellan Fund, have been able to beat market averages for long periods. However, beating the benchmark each year is difficult and most active managers fail to beat the S&P 500 consistently.
Index funds are designed to match the performance of the underlying benchmark, so if the S&P 500 gains 5% in a year, an index fund tracking it will produce the same gain. The index fund will buy and sell stocks in proportion to their weight in the underlying index, so the fund will never "beat the market" since it is the market. Missing out on significant gains is a primary reason some investors stick with active managers, even if the odds are stacked against consistent outperformance.
4. Tax Efficiency
Both mutual and index funds produce dividends and capital gains distributions that count as taxable income. Depending on how long you hold the fund, these payouts can be taxed at the ordinary income level (less than one year) or the long-term capital gains rate (more than one year).
While these sound similar, mutual and index funds produce these taxable events at different rates. Since mutual funds are actively managed in an attempt to beat the market, the portfolio has a higher turnover rate as stocks are bought and sold. Index funds have much less turnover since they only attempt to track a benchmark index, so there are fewer transactions resulting in taxable events. Your holding period matters, but so does the fund’s underlying trading activity.
5. Investment Goals
Index funds have simple investment goals. For example, if an index fund tracks the NASDAQ-100, its goal is to match the return of that benchmark by holding equal amounts of the underlying stocks. Since the NASDAQ-100 is weighted by market cap, the index fund portfolio will also weigh its holdings by market cap.
A mutual fund will have more complex investment goals, and every manager has a different objective and strategy. For example, some funds seek to beat the market by concentrating holdings, using derivatives, or utilizing other sophisticated strategies. If you’re unsure about a fund’s investment goals, read the prospectus, which lays out its plan to achieve its goals; you’ll find a copy on the fund company’s website.
Which is Better: Index Funds or Mutual Funds?
As with most investment questions, the answer depends on personal preferences. Index and mutual funds are similar in that they are baskets of stocks within a single asset, but the divergences are crucial in determining which type an investor should go with.
For example, if you’re a young investor with a long timeline, perhaps you’re willing to pay for a top fund manager who has shown market-beating potential. But if you’re an older investor with a shorter timeframe, a low-cost index fund that keeps fees and taxes to a minimum might be the preferred option.
Our Best Investing Tips
Both mutual and index funds have their place in a financial plan, and so much depends on your preferences and personal goals. Before putting any money into the markets, spend some time thinking about the following investment factors.
Diversification
Diversification is one of the oldest and most practiced risk tolerance techniques, so owning a basket of stocks through a single security like a mutual or index fund makes sense for long-term investors. Diversification wisdom has been handed down from generation to generation in one form or another, i.e., “Don’t put all your eggs in one basket!” However, generational wisdom often has a critical purpose, and diversifying assets is a great way to reduce portfolio volatility.
Time Horizon
Timing the market is challenging and mainly out of our control. However, the time we spend in the market is within our control. The investment time horizon plays a prominent role in determining asset allocation, the types of investment accounts used, tax and estate planning, and more.
Risk Tolerance
Risk can’t be avoided, but it can be managed to fit with investment goals and personal mindsets. How does market volatility make you feel? Can you stomach large drawdowns without getting the urge to sell? Can you stick to long-term goals when short-term uncertainty occurs? Time horizon and risk tolerance are inextricably linked, but even someone with a long timeline may struggle to temper emotions during volatile markets.
Investors Must Select a Fund Based on Personal Preferences
Mutual and index funds make diversification easy, but choosing between them requires a little research and personal evaluation. While some mutual fund managers can beat the market, others struggle to justify their fees. And while index funds make investing simple and affordable, some investors may not be satisfied by matching a broad index. Every investor is different - you must pick the funds that best suit your financial needs.
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