Index Funds vs. Mutual Funds

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by Forbes

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Index Funds vs. Mutual Funds

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Mutual funds and index funds are popular options for diversifying your portfolio without having to hand pick individual stocks.

Both allow you to spread your investments across various assets and industries, decreasing your level of risk. Although these investment options are similar, investors should understand there are several key differences between them before investing their hard-earned money.

Mutual funds are professionally managed investments that pool money from several investors. In 2022, the Investment Company Institute (ICI) reported that just over half of U.S. households owned mutual funds.

When you buy a share of a mutual fund, you purchase a slice of ownership of the fund. That slice entitles you to a proportional share of the income and capital gains the fund generates.

The fund's investment manager invests the fund's assets in a variety of stocks, bonds or other securities, making decisions on what to buy, sell and trade on behalf of the fund's shareholders.

Mutual funds can be actively or passively managed:

For those who own shares of mutual funds, retirement is the most common goal. Mutual funds are a good fit for retirement savings because they provide broad diversification. Other common goals for mutual fund investors include saving for emergencies or a child's college education.

Index funds aren't a separate investment vehicle from mutual funds. Instead, they're passively-managed mutual funds that track the performance of market indices, such as the S&P 500 or the Dow Jones Industrial Average (DJIA).

These funds may contain all of the holdings in an index or only a representative sample. In either case, index funds strive to match the benchmark index's performance as closely as possible.

According to ICI, 48% of households with mutual funds owned equity index funds, or index funds that invest primarily in stocks.

As opposed to actively managed mutual funds, index funds can be good choices for long-term, passive investors. In fact, billionaire Warren Buffett is a proponent of index funds for those saving for retirement because of their low costs.

Whether you're tucking money into an employer-sponsored retirement plan like a 401(k) or an individual retirement account (IRA), the low fees associated with index funds ensure you can benefit from dividends, and the funds tend to be tax efficient because of their buy-and-hold approach.

Index funds and mutual funds provide portfolio diversification, but there are some significant differences to consider.

The objective of the fund will dictate how the portfolio is managed and what investments are included.

Many mutual funds are actively managed by investment professionals with the goal of outperforming market benchmarks.

By contrast, index funds are passively-managed and designed to match their index's performance as closely as possible.

Generally, mutual funds and index funds have relatively low fees, but index funds tend to have lower expense ratios than mutual funds.

ICI reported that the average expense ratio for actively managed equity mutual funds was 0.68%, while the average expense ratio for index funds was just 0.06%.

This means that for every $1,000 invested in an actively managed equity mutual fund, the investor pays a $6.80 fee on average. While for an index fund, investors pay an average of $0.60 for every $1,000 invested. Over time, these increased fees can add up to a significant amount, especially if the mutual fund doesn't outperform the index fund.

Mutual funds are more flexible than index funds because the investment professional managing the fund can respond to market changes and change the fund's holdings.

With an index fund, the fund only invests in securities within a specific index.

Actively-managed mutual funds can be riskier investment options than index funds.

With a portfolio manager trying to outperform the market, there's a chance they will make poor decisions that hurt the fund's performance.

When it comes to index funds vs. mutual funds, fund management is a major differentiator.

An actively-managed fund can be appealing because it aims to beat the performance of market benchmarks. But when considering your options, keep in mind that even the most experienced investment professionals struggle to outperform market indices.

While some investment professionals manage to do it sometimes, their performance is inconsistent. S&P Dow Jones Indices' scorecard compares the performance of actively-managed mutual funds to major indices.

It found that over the course of one year, 51.08% of actively-managed mutual funds underperformed the S&P 500, and 48.92% of actively-managed funds outperformed the S&P 500.* However, those numbers change dramatically over longer periods of time.

*Data as of December 31, 2022

Depending on your goals, low-cost index funds can be a smart option because the majority consistently outperform actively-managed mutual funds.

Mutual funds and index funds are popular investment options for those looking to diversify their portfolios. They both allow you to invest in many securities and industries at once, and due to their relatively low costs, they can be affordable for a wide range of investors.

Before you decide between index funds vs. mutual funds, consider your investment goals and risk tolerance.

Index funds tend to be low-cost, passive options that are well-suited for hands-off, long-term investors. Actively-managed mutual funds can be riskier and more expensive, but they have the potential for higher returns over time.

You can use investing analysis tools like Morningstar or Forbes to view detailed information on the performance and fees of different funds so you can make an informed decision.

If you aren't sure which fund type is best for you -- or if you simply want a checkup to ensure you're on track to meet your goals -- meet with a financial advisor to review your finances and develop an investment plan.

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