Paid non-client promotion: Affiliate links for the products on this page are from partners that compensate us (see our advertiser disclosure with our list of partners for more details). However, our opinions are our own. See how we rate investing products to write unbiased product reviews.
- Index funds and mutual funds let you invest in a variety of stocks, bonds, and assets.
- Mutual funds are actively managed by an investment professional, while index funds are more passive.
- Mutual funds come with much higher fees than index funds, which can cut into your potential gains.
For many beginning investors, hand-picking stocks can seem quite daunting. Fortunately, investing in index funds and mutual funds removes the majority of the legwork, so you can get a headstart on your investing journey.
Both types of funds are beneficial. But first, you must consider your preferred investment strategy (passive vs. active fund management) and the risk and return of index funds vs. mutual funds.
Here's what you need to know when choosing between index and mutual funds.
Index fund vs. mutual fund
Index and mutual funds provide an easy, straightforward way to diversify your portfolio across various assets without having to cherry-pick those investments one by one. The major differences are how those funds are managed and their earning potential.
"Instead of buying shares of many individual companies, investors can purchase shares of a fund of hundreds or thousands of companies," says Matthew Willett, an investment advisor at Watts Gwilliam & Co. "As the companies within the fund either increase in share price or decrease, the value of investors' shares in the fund will change in conjunction."
What are index funds?
An index fund is a type of mutual fund or ETF comprised of a pool of investments that aim to mimic the performance of a certain market index. The is one of the most commonly used indices, but there are many others, including:
- Dow Jones Industrial Average
- Nasdaq Composite Index
- Wilshire 5000 Total Market Index
- Russel 200 Index
With an index fund, money is invested into securities within the aligned index — sometimes all of them, sometimes just a sampling. The ultimate goal is to mirror the overall index's performance and deliver similar returns to the fund's investors.
Index funds are passive investments that don't require regular trading or selling. Since professionals don't actively manage index funds, the fees are smaller, especially when compared to actively managed mutual funds.
Investors usually gain a small percentage annually. According to 2023 data, the S&P 500 returned 26.29% annually. Historically, annual returns have averaged 9.2%.
| Pros | Cons |
|
|
What are mutual funds?
A mutual fund is a company or fund that invests in a variety of assets, including stocks, bonds, and other assets, in the hope of beating the market. Investors purchase fund shares, thereby purchasing a stake in all companies within that portfolio.
"For instance, investors who invested in the Fidelity Magellan fund during the time period Peter Lynch managed it earned an average of 29.2%," says Robert Johnson, CFA chairman and CEO of Economic Index Associates. "That's more than twice what the S&P 500 earned during that time."
Mutual funds come in several types, including money market, bond, target date, and stock funds (index funds fall into this category.)
| Pros | Cons |
|
|
Comparing index funds and mutual funds
Both index and mutual funds can help you achieve your financial goals, but through very different approaches. With one, you'll enjoy passive, hands-off investing that offers steady returns. With the other, you'll get an actively managed fund that could sometimes beat the market.
Management style and objectives
Index funds are passively managed investments that aim to match the returns of broader market indexes, such as emerging markets, large caps, and broad indexes. Since these funds are usually passively managed, you can invest with some of the best robo-advisors or with the assistance of an investment professional.
On the other hand, most mutual funds (aside from index funds) are actively managed. This means an investment professional will regularly sell and purchase shares within the investment portfolio to maximize returns.
While this opens the door for higher potential gains than index funds, it also means returns are unpredictable. In many cases, actively managed funds actually underperform the market. According to S&P Dow Jones Indices data, 60% of large-cap funds underperformed the S&P 500 in 2023.
Costs and fees
When comparing index funds vs. mutual funds, fee-conscious investors often prefer indexes. Since professionals don't actively manage index funds, the fees are smaller. Index funds generally have lower turnover rates, resulting in fewer capital gains distributions. But you should still be mindful of investment minimums and expense ratios.
Mutual funds are more expensive than index funds, as you'll need to pay for the expense of active management by a professional.You'll also be subject to additional management, administrative, legal, custodial, and transfer agent expenses.According to the Investment Company Institute (ICI), the average fee for equity mutual funds is 0.42%. On index funds, it's just 0.15%.
Making the choice: Index funds or mutual funds
In short, index funds are better suited for beginners and investors who prefer a hands-off investment style. These funds are more transparent, offering low-cost diversification through a long-term buy-and-hold strategy with mitigated risk and lower fees.
"An index fund would be best for someone who did not have a lot of money and was just starting to invest," says Josh Simpson, gift planning officer at Kansas State University Foundation. "This would allow them to achieve diversification with their investment without having to spend hours learning how to invest."
Conversely, actively managed mutual funds offer the potential for higher returns through strategic selection of investments. Mutual fund managers aim to outperform the market benchmark, which translates to higher fees and risk than index funds.
Another aspect to consider is the performance comparison of index and mutual funds. Despite the allure of a higher return, mutual funds historically perform worse than index funds. Overall, index funds perform better, but they can't outperform the market.
"The reason someone would choose an actively managed mutual fund is that if one can identify a fund manager that can consistently beat the market, one can accrue tremendous wealth," says Johnson.
At the end of the day, both fund types are great additions to an investment portfolio. You don't have to pick just one, either. It's common for investors to have both index and mutual funds in their portfolios to further diversify their holdings.
Index fund vs. mutual fund — Frequently asked questions (FAQs)
Can you invest in both index funds and mutual funds?
It's common for investors to invest in both index funds and mutual funds in their portfolios for further diversification and possibly get higher returns. Make sure you understand the benefits and risks involved in each investment vehicle before buying, though.
Which is better for long-term investing, index funds or mutual funds?
Index funds are generally considered the better option for long-term investing because of the lower fees and historically better performance. Index funds encourage a buy-and-hold strategy, preventing investors from impulsively buying and selling.
Are index funds less risky than mutual funds?
Index funds are usually less risky compared to mutual funds since the goal is to mimic the market rather than beat it. Index funds tend to perform better as well. However, the risk level also depends on the market or index the fund tracks.
How do you choose between an index fund and a mutual fund?
When choosing between an index fund or a mutual fund, the best investment vehicle for you depends on your preferred trading strategy, risk tolerance, expertise, and how much you're willing to spend on fees. Index funds are generally cheaper and better for passive investors. Mutual funds, on the other hand, are riskier and incur higher fees since professionals actively manage them.
Do mutual funds have higher returns than index funds?
Mutual funds aim to outperform the market, increasing the possibility of a higher return than index funds that aim to match the market. However, mutual funds don't always succeed and often underperform compared to the market.
Aly J. Yale is a freelance writer, specializing in real estate, mortgage, and the housing market. Her work has been published in Forbes, Money Magazine, Bankrate, The Motley Fool, The Balance, Money Under 30, and more. Prior to freelancing, she served as an editor and reporter for The Dallas Morning News. She graduated from TCU's Bob Schieffer College of Communication with a focus on radio-TV-film and news-editorial journalism. Connect with her on TwitterorLinkedIn.
Junior Investing Reporter
Tessa Campbell is a Junior Investing Reporter for Personal Finance Insider. She reports on investing-related topics like cryptocurrency, the stock market, and retirement savings accounts. She originally joined the PFI team as a Personal Finance Reviews Fellow in 2022.Her love of books, research, crochet, and coffee enriches her day-to-day life.
Top Offers From Our Partners
SoFi Checking and Savings Earn up to 4.60% APY on savings balances and up to a $300 bonus with qualifying direct deposit. FDIC Insured. There is no minimum direct deposit amount required to qualify for the 4.60% APY for savings. Members without direct deposit will earn up to 1.20% annual percentage yield (APY) on savings balances (including Vaults) and 0.50% APY on checking balances. Interest rates are variable and subject to change at any time. These rates are current as of 10/24/2023. There is no minimum balance requirement. Additional information can be found at http://www.sofi.com/legal/banking-rate-sheet. To earn the $300 bonus, the customer must complete a direct deposit with a minimum initial deposit of $250 in a new SoFi Checking and Savings account within 45 days of clicking to qualify (offer expires 12/31/24).
