Index Fund vs. Mutual Fund: What's the Difference? (2024)

Index Fund vs. Mutual Fund: What's the Difference? (1)

When you’re putting together a portfolio, you’ll notice there are a lot of different types of funds to choose from. So it’s easy to get confused about what the terms “mutual fund” and “index fund” refer to. The two terms refer to distinct categories: Mutual fund refers to a fund’s structure, whereas index fund refers to a fund’s investment strategy. Many, but not all, index funds are structured as mutual funds, and many mutual funds are index funds. Generally speaking, though, “index fund” refers to a fund whose investments closely track a market index, while “mutual fund” refers to a broad class of investment funds that follow a range of investing strategies. A financial advisor can help you understand the similarities and differences between mutual funds vs. index funds so that you can make an informed investing decision.

What Is a Mutual Fund?

A mutual fund combines the funds of investors who mutually pool their monies to buy and sell securities. Investing in a mutual fund is not trading shares of specific companies held by the mutual fund. Instead, it is trading shares of the mutual fund company itself. Investors buy and sell their stakes in mutual funds at a price set at the end of a trading session – their value does not fluctuate throughout the trading session.

Most mutual funds, which often carry minimum balance requirements, fall into one of four categories:

  • Money market – This type of mutual fund invests inhigh-quality, short-term investments issued by U.S. corporations and federal, state, and local governments. Though low-risk, investors’ money is not FDIC insured.
  • Fixed-income – These funds hold debt issued by corporations or government entities, such as municipalities, counties, states and the federal government.
  • Equity– There are several types of stock or equity funds: growth, income, index and sector.
  • Target-date – Also known as lifecycle funds, target-date funds are designed for people with specific retirement dates in mind. Over the course of a customer’s life, the asset allocation of these funds shifts from being stock heavy to bond heavy. The younger a customer is, the higher the allocation of stocks. The older a customer is, the higher the allocation of fixed-income securities.

When determining what type of fund is right for you, it can also be helpful to consider some of the pros and cons of mutual funds.

What Is an Index Fund?

The term “index fund” refers to the investment approach of a fund. Specifically, it is a fund – either mutual or exchange traded (ETF) – that aims to match the performance of a particular market index, such as the S&P 500 or Russell 2,000, or a specific commodity or class of commodities.Unlike a mutual fund, an ETF has a value that fluctuates on a public exchange throughout a trading session.

An index fund differs from an actively managed fund in one big way. In an actively managed fund, investments are picked by a fund manager trying to beat the market. An index fund does not seek to beat the market, only to match it.

Investing in an index fund can bring these benefits:

  • Lower fees
  • More dependable returns over time
  • Works well for beginner investors
  • Offers strong diversification

Index Funds vs. Mutual Funds: Management, Goals and Costs

Aside from the distinction described above, there are usually three main differences between index funds and mutual funds. These differences are how decisions are made about a fund’s holdings, the goals of the fund, and the cost of investing in each fund. Here’s a breakdown of each differentiator and how it may apply to you.

Comparing Active vs. Passive Investment Management

Many, but not all, mutual funds areactively managed. This requires the fund manager to make daily or even hourly trading decisions.

An index fund – whether structured as a mutual fund or ETF – takes a more passive approach. There is no fund manager actively managing an index fund since the fund is tracking the performance of an index. Index funds aim to buy and hold the securities that coincide with the indexes they track. Therefore, there is no need to buy and sell securities regularly. This is one of the biggest differentiators of index funds vs. mutual funds.

Since there is no fund manager actively managing an index fund, the fund’s performance is solely based on the price movement of the shares within the fund itself. However, with an actively managed mutual fund, the performance is based on the investment decisions the fund managers make. Fund managers are free to choose the securities that best meet the investment objective and character of the fund.

There is a constant debate on which is better, actively or passively managed funds. According to the SP Indices, 78% of large-cap funds underperformed the S&P 500 within five years. This highlights that even though the market has experienced high volatility in the last few years, active funds don’t necessarily yield better-performing funds.

Investment Goals

Another difference is the investment objective each type of fund offers. With index funds, the goal is to simply mirror the performance of an index, while with a mutual fund, the objective is to outperform the market. Essentially, actively managed funds strategically select investments that will yield a higher return than the market.

Investors who seek higher-than-average returns may be more drawn to mutual funds. However, since there is more work required to actively manage a mutual fund, it may cost more. This leads us to our next big difference.

Costs of Investing

Running an actively managed fund generally costs more than running an index fund. This is because actively managed funds tend to have more expenses such as fund managers’ salaries, bonuses, office space, marketing and other operational expenses. Usually, the shareholders absorb these costs with a fee known as the mutual fund expense ratio.

It’s important to note that the higher the investment fees are, the more they dip into your returns. If you purchase shares of an actively managed fund expecting to yield above-average returns, you may be disappointed, especially if the fund underperforms.

However, index funds have fees as well, though the lower cost of running such a security usually results in lower fees. Remember, the lower the management fees, the more the shareholder can receive in returns.

Bottom Line

Index Fund vs. Mutual Fund: What's the Difference? (3)

Some, but not all, mutual funds are index funds. An index fund, which can be either a mutual fund or an ETF, tracks a particular market index with the goal of matching its performance. Mutual funds and index funds can be great options for folks who don’t want to take theDIY approachto investing.But before you invest in either type of fund, it’s important to make sure you understand how that fund works, what the investment objective is and what fees the fund has. Remember that the fees of an index fund or mutual fund can dip into your returns.

Tips for Investing

  • A financial advisor could help you understand how mutual and index funds will fit into your financial plan.Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • If you don’t have a lot to invest, you might want to consider arobo-advisor.Robo-advisors, which are entirely online, offer lower fees and account minimums than traditional financial advisors.

Photo credit: ©iStock.com/Nuthawut Somsuk, ©iStock.com/Laurence Dutton, ©iStock.com/megaflopp

Index Fund vs. Mutual Fund: What's the Difference? (2024)

FAQs

Index Fund vs. Mutual Fund: What's the Difference? ›

Mutual funds are actively managed, index funds are passively managed. Mutual funds have active management, meaning they have a team of financial experts looking for the right stocks to include in their fund.

What is the difference between mutual funds and index funds? ›

The main difference is that index funds are passively managed, while most other mutual funds are actively managed, which changes the way they work and the amount of fees you'll pay.

What are the differences between index funds and mutual funds quizlet? ›

Index funds seek market-average returns, while active mutual funds try to outperform the market. Active mutual funds typically have higher fees than index funds. Index fund performance is relatively predictable over time; active mutual fund performance tends to be much less predictable.

How is a mutual fund different from an index fund in EverFi? ›

How is a mutual fund different than an index fund? Mutual funds are actively managed while index funds are passively managed.

What is an advantage to investing in an index fund rather than a mutual fund? ›

Lower costs: Index funds typically have lower expense ratios because they are passively managed. Market representation: Index funds aim to mirror the performance of a specific index, offering broad market exposure. This is worthwhile for those looking for a diversified investment that tracks overall market trends.

Do you pay taxes on index funds? ›

Index mutual funds & ETFs

Constant buying and selling by active fund managers tends to produce taxable gains—and in many cases, short-term gains that are taxed at a higher rate.

What is the best mutual fund to invest in in 2024? ›

Best-performing U.S. equity mutual funds
TickerName5-year return (%)
GQEPXGQG Partners US Select Quality Eq Inv19.33
FGRTXFidelity Mega Cap Stock17.23
SSAQXState Street US Core Equity Fund16.89
FGLGXFidelity Series Large Cap Stock16.88
3 more rows

What are the pros and cons of a mutual fund? ›

One selling point is that they allow you to hold a variety of assets in a single fund. They also have the potential for higher-than-average returns. However, some mutual funds have steep fees and initial buy-ins. Your financial situation and investment style will determine if they're right for you.

What is the major difference between an index fund and an ETF? ›

The biggest difference between them is that ETFs trade intraday at various prices during exchange hours and index mutual funds can be bought or sold only after the market closes each day, at a fund's net asset value. CNBC. “In One of the Most Volatile Markets in Decades, Active Fund Managers Underperformed Again.”

How are mutual funds and investment funds different? ›

The units in a mutual fund always reflect the value of the underlying investments of the fund (minus any charges). This is not the case for an investment trust. That's because the share price will reflect market sentiment, rather than simply the value of the assets.

What is the difference between index funds and diversified mutual funds? ›

Diversification Shortcut: Index funds passively track benchmarks; mutual funds aim to outperform. Investment Accessibility: Invest in mutual funds via company or trade ETFs like stocks for added convenience. Cost and Performance: Index funds cost less, have lower taxes. Most prefer them for cost-effectiveness.

Which savings account earns the least money? ›

Traditional savings accounts from large, brick-and-mortar banks usually earn the least money. If making a good return on your cash is important to you, consider an online-only, high-yield savings account or CD instead.

What is a mutual fund everfi? ›

Mutual funds are investment vehicles that pool money from multiple investors to invest in a diversified portfolio of securities such as stocks, bonds, or other assets. They can focus on specific areas or be quite broad.

Which is better, a mutual fund or an index fund? ›

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.

What is the main disadvantage of investing in index funds? ›

No Control Over Holdings

If an investor buys an index fund, they have no control over the individual holdings in the portfolio. You may have specific companies that you like and want to own, such as a favorite bank or food company that you have researched and want to buy.

What is the return rate of index funds? ›

Equity Hybrid Debt Solution Oriented Others Filter
Scheme NamePlan1Y
ICICI Prudential Nifty Bank Index Fund - Direct Plan - GrowthDirect Plan11.54%
ICICI Prudential Nifty Bank Index Fund - Direct Pan - GrowthDirect Plan11.54%
Motilal Oswal S&P 500 Index Fund - Direct Plan GrowthDirect Plan25.85%
19 more rows

Are mutual funds or index funds riskier? ›

Investment Risks

Actively managed mutual funds may have higher expense ratios, leading to a potential performance lag against the market. Conversely, the risk of underperforming the market benchmark is prevalent in index funds, particularly when active management outperforms the market index.

What is a disadvantage of a mutual index fund? ›

The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).

Is it better to just invest in index funds? ›

Index funds are popular with investors because they promise ownership of a wide variety of stocks, greater diversification and lower risk – usually all at a low cost. That's why many investors, especially beginners, find index funds to be superior investments to individual stocks.

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