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 can be beneficial, and sometimes index funds are simply a type of mutual fund that aims to match the returns of an index, like the S&P 500. Other times, however, mutual funds are actively managed, meaning the fund manager makes investment decisions to try to beat its benchmark.
So, when deciding on what funds to invest in, you must consider your preferred investment strategy (passive vs. active fund management) and the risk and return of different index funds and active mutual funds.
Here’s what you need to know when choosing between index and active mutual funds.
Index fund vs. mutual fund
Index and mutual funds generally provide an easy, straightforward way to diversify your portfolio across various assets without having to cherry-pick those investments one by one.
“Instead of buying shares of many individual companies, investors can purchase shares of a fund [that has exposure to] 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.”
However, not all index funds and mutual funds are the same. The terminology also can get a little confusing, as some refer to a mutual fund vs. index fund as two opposite types of funds, but technically mutual fund refers to the fund structure, and index fund refers to the investment strategy. And there can be overlap in the sense that there are some index mutual funds.
What are index funds?
An index fund is a type of mutual fund or exchange-traded fund (ETF) composed of a pool of investments that aim to mimic the performance of a certain market index. The S&P 500 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
- Russell 2000 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, meaning the fund manager simply tries to match the index and can often buy and hold investments, rather than regularly buying or selling securities to try to beat the benchmark. As such, the fees are generally lower than actively managed mutual funds.
While it might seem like index funds deliver subpar returns since they’re not trying to beat the benchmark, the reality is that active managers often struggle to outperform. Even if they slightly beat the index, fees often take them below the net performance of index funds, so you have to carefully weigh factors like costs and potential upside when choosing between these strategies.
Because indexes like the S&P 500 tend to provide attractive long-term returns — the S&P 500 averages roughly 10% per year — many investors are happy to take the index returns and not risk underperformance. That said, some index funds are more niche, and the indexes they track may lag the S&P 500, so be sure you understand what you’re investing in:
Pros and cons of index funds
Here are some of the main pros and cons of broad-based index funds like those that try to match the S&P 500 :
What are mutual funds?
A mutual fund is technically a company that acts as a pooled investment vehicle to invest in a variety of assets, such as stocks or bonds, depending on the fund’s objective. Investors purchase mutual fund shares, which effectively means they’re purchasing a stake in all the companies within that portfolio.
Some mutual funds are passively managed, meaning that they’re index funds. Others, however, are actively managed, where the fund manager tries to beat the index, such as by buying different stocks than what the index holds or trying to time the market. Although many active managers struggle to beat the index, there are certainly plenty of cases where active managers do have outsized returns.
“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 R. Johnson, CFA, founder, chairman and CEO of Economic Index Associates. That’s around “twice what the S&P 500 earned during that time.”
Mutual funds come in several formats based on the investment strategies and goals, such as money market funds that invest in short-term, high-quality bonds (which differs from a money market bank account), fixed income funds that invest in corporate bonds, and equity funds that might be index funds or actively managed funds.
Pros and cons of active mutual funds
Because there are many different types of mutual funds, it’s hard to generalize the pros and cons. Here, however, we’ll compare the pros and cons of active mutual funds.
Comparing management style, fees, and more
Both index and active mutual funds can help you achieve your financial goals, but through very different approaches. With one, you’ll enjoy passive, hands-off investing that typically offers solid long-term returns in line with the general market. With the other, you’ll get an actively managed fund that could sometimes beat the market but sometimes lag.
Management style and objectives
Index funds are passively managed investment vehicles that aim to match the returns of broader market indexes, such as the S&P 500 or the Russell 2000, the latter of which tracks small caps. You can often invest in index funds through some of the best robo-advisors, or an investment professional can help you choose index funds that align with your investment objectives.
In comparison, active mutual funds involve a fund manager trying to beat an index, such as by regularly selling and purchasing shares to try to maximize the returns of its investment portfolio.
While this opens the door for higher potential gains than index funds, it also means returns might lag the index. The broad stock market might be up while an active mutual fund is down, for example, although the opposite can also occur.
Costs and fees
When comparing index funds vs. active mutual funds, fee-conscious investors often prefer indexes. Since professionals don’t have to do as much active research or trading in index funds, the fees are less. Active funds might also have higher administrative, custodial and other costs that make the total expense ratio higher. Also, index funds generally have lower turnover rates, resulting in fewer capital gains distributions, meaning you might pay less in taxes.
Still, much depends on the specific fund. Be sure to carefully compare investment minimums and expense ratios of different types of funds before investing.
Making the choice: Index funds or mutual funds
Typically, index funds are better suited for beginners and investors who prefer a hands-off investment style. These funds are generally more transparent as you know exactly what their investment strategy looks like, whereas an active fund manager might have a more varying approach that isn’t always apparent right away.
“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. So, active mutual funds might work well for those willing to take more of a chance or have done extensive manager research and have reason to believe a particular fund will outperform the index.
“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.
Still, that’s far easier said than done. A manager that performed well in the past is by no means guaranteed to do well in the future. In fact, even high-performing managers often have lagging periods.
At the end of the day, both fund types can be 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 active mutual funds in their portfolios to further diversify their holdings.
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FAQs about index funds vs. mutual funds
Technically, a mutual fund and index fund can be the same thing. The difference between index and mutual funds is that a mutual fund refers to the structure of a fund, such as how a mutual fund structure differs a bit from an ETF. Meanwhile, an index fund refers to a passive rather than active investment approach. Some mutual funds are index funds, but others are active funds.
The S&P 500 is not a mutual fund. It’s an index, which is not directly investable. But there are many mutual funds that invest in the companies within the S&P 500, aiming to match the returns of the index.
An equity mutual fund generally has the highest allocation toward stocks, but there can be some differences among various funds. While many equity funds only hold stocks, some might hold some cash or a small slice of other assets like government bonds.
Some mutual funds are index funds, but it’s also common for investors to invest in both index funds and active 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.
While the choice depends on your investment goals and beliefs, index funds are often 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, which tends to work well for many investors, whereas active funds might be used in certain niche markets or during tricky market conditions.
