What are the similarities between index funds and mutual funds?
The term “index fund” technically refers to an investing strategy rather than the fund itself.
Since you can’t directly invest in an index, you invest in a type of fund, such as an ETF or a mutual fund, that is constructed of investments that mirror a market index, such as the S&P 500.
The index fund consists of these investments in appropriate ratios and weights, so the fund's returns mimic those of the index.
Mutual funds are professionally managed funds composed of investments designed to produce higher returns for investors.
Mutual funds can be designed with different investment types and strategies in mind.
If you’re looking for a mutual fund focused on energy securities, you’ll find it. If you’re looking for a mutual fund that produces income, there’s one for that, too. Actively-managed mutual funds usually come with higher fees.
Similarities between the two investments are outlined below.
Professionally managed
Both index funds and mutual funds are professionally managed, though mutual funds that aren’t index funds are more actively managed and more costly.
Simple investing
Both mutual funds and index funds are easy to trade and offer hands-off investing.
Diversification
Investing in either mutual funds or index funds offers a simple way to diversify your portfolio. You gain exposure to the full spectrum of investments that make up the index fund or mutual fund.
What’s the difference between index funds and mutual funds?
Index funds and mutual funds both offer ways you can invest in a diverse portfolio, but they don’t operate the same way, and it’s the major differences that change the way they affect your money.
| Index funds | Mutual funds | |
|---|---|---|
| Management | Passive | Active |
| Structure | Track an index | Varied investing approaches |
| Fees and cost | Low fees and higher costs | More fees and higher operating expenses |
| Tax efficiency | Generally more tax efficient | Generally less tax efficient |
| Returns | Designed to produce average returns | Managed to outperform the market, though many do not |
Management
Index funds are generally considered passive investments because they’re not actively managed. There’s not much trading activity that occurs on a daily basis, and they remain as steady as the index. The opposite is true of mutual funds, where money managers make trades with the goal of outperforming the market.
Structure
Index funds are limited to tracking a market index, while mutual funds can have a wide variety of investing approaches.
Fees and cost
Actively-managed mutual funds will most likely have higher fees than index funds. Index funds come with lower operating expense ratios and fewer fees all around.
Tax efficiency
Mutual funds are generally less tax-efficient than index funds. That’s in large part because the active trading in a mutual fund creates a “taxable event,” and you may need to pay capital gains (paying capital gains may also be dependent on where you hold these investments, as brokerage accounts, Roth accounts, and traditional retirement accounts have different tax treatments).
Returns
When it comes to returns, it’s a mixed bag for mutual funds and index funds. Index funds should produce average returns, but it’s also possible they can underperform the market. And while mutual funds aim to produce returns better than the market, they also can underperform.
What are the pros and cons of index funds vs mutual funds?
Index funds and mutual funds both have advantages and disadvantages, though some of the benefits overlap for index mutual funds.
Index funds
Pros
Lower cost: Index funds typically have lower costs, especially since they’re not actively managed and don't incur all kinds of fees.
Diversified investment portfolio: Index funds offer exposure to a wide range of investments through a single investment vehicle.
Easy to invest: You can invest in an index fund with many providers at a low cost.
Consistent returns: Indexes have often performed well over long periods.
Cons
Tracking errors: Your index fund may not perfectly replicate the results of a market index, sometimes due to fund rebalancing, which can be disappointing.
Less control: You won’t need to make decisions about investments, but you might not like that if you’re a hands-on investor.
Market risk: You can lose money in an index fund.
Lower returns: Since index funds are passively managed and follow an index, they may underperform.
Mutual funds
Pros
Professional management: Mutual funds are managed professionally to optimize returns for investors.
Many different investment approaches: There are mutual funds for all kinds of investing strategies and categories.
Goal is to outperform the market: A well-managed mutual fund should outperform the market (though it's worth noting that many do not).
Diversified portfolio: As mutual funds have a variety of underlying investments, they typically offer solid diversification.
Matching funds: Your company may provide matching funds to a retirement account you can use to invest in mutual funds (this depends on what your company offers).
Cons
Fees: Mutual funds can tack on a lot of fees and higher costs than index funds.
Not as tax-efficient: Mutual funds may not be as tax-efficient as index funds.
Less frequent trading: Mutual funds only trade once per day.
Higher minimums: Some mutual funds require a higher minimum investment.
Returns aren’t guaranteed: Even with professional management, mutual funds don’t always outperform the market. Fees can diminish returns faster than you realize.
Should I invest in an index fund or mutual funds?
You can invest in both index funds and mutual funds as part of your portfolio, though your investing style, goals, and time horizon may influence which you choose right now.
Index funds are best for investors who:
Like passive investing
Like low fees
Like simplicity
Are looking for an easy way to diversify their investment portfolio
Mutual funds are best for investors who:
Also like passive investing, but appreciate active, professional management
Have a specific investing approach
Want exposure to a particular sector
Feel the costs are worth it
Bottom line
Both index funds and mutual funds can be useful tools in your financial plan and investment portfolio.
Deciding between the two may come down to a case-by-case basis, and advice from a financial advisor can help you feel confident in decisions that will help you reach your financial goals.
Unbiased can match you with a financial advisor who can help determine which fund type best fits your investment strategy.