Index Funds vs. Mutual Funds – Which is the Right Investment for You?

When I first learned about investing in the stock market, I thought you could only buy individual company stocks.

You follow one company and based on their performance, you win, or you lose. Simple. It was only after a decent amount of research and some wisdom that comes with age that I came to realize the stock market affords you several paths of entry.

Just like there's no single investment vehicle to save your money, there isn't a single path to invest. If you're into gambling, individual stock picking might be your game.

But for those of us who are a bit more risk-averse, it's worth taking a look at index funds and mutual funds instead. While seemingly similar, there are important distinctions between the two and different investing situations where you may prefer one over the other.

In this article, we'll cover:

• What are index and mutual funds?
• How do they differ?
• What are the pros and cons of index funds vs. mutual funds
• Tips for a solid investing strategy

What is an Index Fund?

An index fund is a portfolio of stocks or bonds wrapped into a single fund that tracks a broader market index. For example, you can’t directly invest in the S&P 500, but you can buy shares of an index fund designed to track the companies in the S&P 500.

Since there’s relatively little management needed after index funds are created, they are considered passively managed. These investments tend to be lower risk, lower cost, and produce pretty nice returns as far as passive investments are concerned.

A quick note: It’s important to distinguish between an index fund and an exchange-traded fund (ETF) as the terms are often used interchangeably. These are two lower-cost options when you compare them against mutual funds.

So in terms of ETF vs. mutual funds pros and cons, a key difference is that ETFs are bought and sold like stocks with prices that fluctuate throughout the day, often with no minimum buy-in amount. They also tend to be more specific and can mirror commodities, industries, other funds, or indexes.

What is a Mutual Fund?

As opposed to its passively managed counterpart, a mutual fund is an actively managed portfolio of holdings. This means a fund manager is behind the scenes deciding exactly what holdings should be put into or removed from the fund regularly.

The people who buy into the fund rely on the fund manager’s expertise to get returns that beat the market.

What's the Difference?

All whiskey is bourbon, but not all bourbon is whiskey. Or is it the other way around? It's the same kind of deal with index and mutual funds. Most index funds structurally resemble mutual funds, and many mutual funds are also index funds.

So what's the difference? The answer is in the investment strategy.

Since mutual funds are actively managed, meaning someone is responsible for actively investing the fund's securities, it's up to the fund manager and their company to decide how and why changes in investments occur.

That means more trades, more upside potential, and also more downside potential. According to Vanguard, one of the most significant players in the investment game, over the past 15 years, only 37% of active fund managers have outperformed their benchmarks.

With a passively managed index fund, more of a set it and forget it mentality is used, meaning the strategy is to simply track the market index. Generally, the holdings in an index fund only change when the index it's tracking makes a change.

Because mutual funds are actively managed, they also tend to have higher associated costs because the fund manager needs a payday too. Index funds can keep costs extremely low due to the low overhead associated with fund management.

According to Morningstar's fund fee study, in 2019, the average expense ratio for passive funds was .13%, while the average fee for actively managed funds was .66%. That difference of only half a percent may seem small, but it adds up over time. For a clearer understanding of the actively managed funds vs. index funds distinction, Minority Mindset offers a more in-depth analysis of the varied aspects along with the pros and cons of each.

What Is the Difference Between a Managed Mutual Fund and an Index Mutual Fund?

The passive and active management strategy of index funds vs. mutual funds leads to several key differences. An actively managed mutual fund may involve day-to-day monitoring and investment decisions (trading) whereas for index mutual funds there is no need for active surveillance and charge to manage the portfolio.

Since there is no active investment decision or management involved for index funds, the performance is not reliant on active trading decisions and is hence governed by price alone. An investment in an index fund depends on the rise or fall of the individual stocks in the fund. This chief attribute is what defines index funds as passive investments.

Actively managed mutual funds have a fund manager in charge of making the investment decisions. They determine not only which investments to buy in and out of but how many units or stocks to purchase and when. Such type of active management may even require daily effort and commitment, which explains the relatively higher cost of actively managed mutual funds.

Crucial Distinction of Index vs. Mutual Funds – Cost vs. Returns

Fees – Index Funds vs. Mutual Funds

Index funds invest only in a specific list of securities that includes stocks of S&P 500 companies, so they don’t need to be actively managed. Since they don’t require regular or even daily investment decisions as explained previously, naturally these funds come with a low cost, which is a huge benefit for investors.

More specifically, an index fund does not aim to outperform the market as does a mutual fund, and hence sticks to a specific index. However, it includes diversification in different sectors within a given index, which tends to reduce the risk. So index funds are said to include diversification albeit with predictability, which reduces the likelihood of potential losses over a period of time.

In terms of the cost of index funds vs. mutual funds, the latter need to be actively managed and therefore have higher fees that not only include the fund manager’s paycheck but also other costs associated with the fund. For instance, besides investment manager’s fees, there are expenses for running the office that includes office space, administration and marketing, and all employees’ salaries and bonuses. Investors collectively pay for all these expenses – look for the mutual fund expense ratio which indicates the potential fees that the investor will eventually incur.

Potential Gains – Index Funds vs. Mutual Funds

Another advantage of index funds is that they do not vary from year to year, resulting in higher returns over the long term. On the other hand mutual funds may vary from year to year and their high performance over some years may be negated by their low performance over other years, resulting in lesser returns. As a result, index funds may even perform better than some actively managed mutual funds despite their apparent low return profile, but of course that may not always be the case.

All factors considered, when choosing between index funds and mutual funds it’s imperative to not only consider the returns but also the costs and whether the costs may eventually outweigh the returns. In case of managed mutual funds especially, due diligence may be required given their high costs, which tend to accrue over a given period of time. More importantly since these costs are deducted annually from the returns earned by an investor, they reduce the amount left in the account for compounding, thereby reducing the potential gains over a duration.

Index Funds vs. Mutual Funds – Pros & Cons

In a nutshell, given their inherently different characteristics, the index fund vs. mutual fund comparison includes several key considerations, which are discussed below:

Index Funds

Pros

• Lower Fees
• Generally high returns when the market performs well
• Diversification with predictability

Cons

• Minimum purchase amount is around $3,000 for most companies

Best For

• Buy and hold long-term investors who enjoy low-fee, low-risk investments

Mutual Funds

Pros

• Diversification
• Professional portfolio manager
• Broad range of options for holdings

Cons

• Higher fees
• Less visibility into holdings
• Potential for higher taxes due to higher volume of trades

Best For

• Investors who believe in a fund manager’s ability to outperform the broader market

When to Invest in Index Funds vs. Mutual Funds

It's essential to consider your long-term investing goals when deciding whether to invest in index or mutual funds. Over the long-term, index funds tend to perform exceptionally well, while actively managed mutual funds have been known to perform well in the short-term.

Since index funds mirror the broader markets, they are especially subject to economic volatility. So investors who can stomach the downturns and are investing for the long haul may view them as a good option as markets generally trend upward over time. 

I am firmly in this camp.  My investments have a sufficient time horizon that I trust in the market’s ability to recover no matter what downturns may come in the next 20-30 years.

But investors who struggle in times of economic instability may be calmed by a mutual fund's more hands-on approach. Sometimes merely having someone with eyes on the fund holdings can keep people from jumping ship at inopportune times.

Where Can I Lose All of My Money – Index Fund vs. Mutual Fund?

Technically a fund can lose all of its value, but the odds of that happening are extremely unlikely. This was definitely one of my concerns when I first began investing.  I was relieved to know that the funds I’m investing in each house tens, hundreds, or thousands of companies.

Since index and mutual funds are combinations of other investments, it would take a severe economic downturn to put these funds in a position where all investments or companies within the portfolio cease to exist.  And if that happens, trust me when I say we have much bigger problems.

What Should My Investing Strategy Be?

Given the several factors that rule the index fund vs. mutual fund distinction, it can be challenging to decide where to put your money for the long-term. However, there are a few sound investing principles to follow to make sure you don’t go wrong, whether you choose the former or the latter investment option.

• Leave timing to the clocks: Trying to time the market is often a futile game. And in my household, it tends to create nothing but frustration. For me, the only guarantee in market timing is the second I try to sell off holdings to beat the market; whatever I just sold is going to go through the roof.
• Seek consistency: Dollar-cost averaging is an extremely popular investment strategy for a good reason. This strategy is when people invest the same amount at regular intervals, often weekly or monthly, regardless of the market situation. The thought process is that the market will average out over time so that you're getting the best deal possible. It's far better to have a consistent investment strategy than to only invest when the market is down.
• Don't ignore fees: Any investment where fees are present should lead to projections for how those fees will impact your money over time. You may not think a .75% difference in fees makes much of a difference, but when you project that out over 20 years, it can dramatically change the investment outcome.

You'll want to decide the most appropriate fund type based on your personal investing style and overall financial strategy. Regardless of which you choose, know that the most important thing is that you're investing in your future, and you're taking the time to learn about your options.

Contributor’s opinions are their own. Always do your own due diligence before investing.

Keep Reading:

• Hands-Off Investing Strategies: ETFs
• Do I need a Financial Advisor to Invest?
• How Stock Investing Works – A Getting-Started Guide for Beginners