Index Fund vs Mutual Fund: What’s the Difference?

what is the difference between mutual fund and index fund

The cost disparity often favors index funds, which tend to have lower expense ratios and fewer additional charges than mutual funds. Index funds are a type of mutual fund that focuses on mimicking a portion of the market rather than trying to outperform the market. In general, it’s usually better to choose an index fund over a more expensive, actively managed fund.

  1. The decision revolves around whether investors prioritize consistent returns and cost-effectiveness (index funds) or seek potential outperformance and active management strategies (active mutual funds).
  2. A similarity between mutual funds and index funds is that they both easily give investors a way to get exposure to many different securities.
  3. NerdWallet does not and cannot guarantee the accuracy or applicability of any information in regard to your individual circumstances.
  4. There is a constant debate on which is better, actively or passively managed funds.
  5. Another cost to consider is that actively managed funds generally trade more frequently than passive index funds.

What distinguishes an index fund, however, is that an index fund is a passively managed fund that merely aims to track a benchmark index’s returns, whereas an actively managed fund aims to outperform. An index fund manager buys the exact same securities as tracked by the index with the exact same weightings. 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.

Differences between mutual funds and index funds

Investors who sell shares in a mutual fund or index fund for a profit will have to pay capital gains taxes, regardless of the type of fund they invested in. Index fund managers, by contrast, tend to make fewer transactions, meaning index funds will usually realize fewer gains. That means that index funds can create less tax liability for investors in the short term. For example, if you invest in an S&P 500 index fund, it will try to mimic the performance of the S&P 500. When the S&P gains 1% in value, for example, the fund will aim to gain 1%.

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%. 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. This requires the fund manager to make daily or even hourly trading decisions. 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.

Goals and style of management

Each has pros and cons, and the ideal choice varies based on individual preferences and financial objectives. Choosing between index funds and active mutual funds hinges on individual investment objectives. Index funds tend to have lower fees and tax efficiency and typically mirror market benchmarks, suitable for those prioritizing broad market exposure at minimal costs. Conversely, active mutual funds seek to outperform the market and offer the potential for higher returns but may incur higher fees and could underperform their benchmarks. The decision revolves around whether investors prioritize consistent returns and cost-effectiveness (index funds) or seek potential outperformance and active management strategies (active mutual funds). A mutual fund is a financial product that uses money from public investors to purchase and maintain a diversified portfolio of stocks, bonds or other capital market securities.

what is the difference between mutual fund and index fund

Yet others invest in non-stock securities such as bonds or derivatives. 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.

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. 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.

Costs of Investing

Although you won’t own the individual underlying asset, you’ll own a share of the fund. This strategy is convenient as it gives you access to a diversified portfolio by purchasing a single share of an ETF, mutual fund or index fund. Another cost to consider is that actively managed funds generally trade more frequently than passive index funds. That can trigger more taxable events for shareholders and create additional costs. What’s more, shareholders have little control over those decisions despite being left with the tax bill.

After you factor in all the fees, the better-performing mutual fund still outperforms the index fund by about $26,000—and that’s assuming you don’t add a single penny! The gap widens even more if you invest consistently month after month, year after year. And the good news is you don’t have to do all this research on your own.

Investing Strategy

This means that passively managed funds, like index funds, are much cheaper to invest in than actively managed funds. The fund’s dedicated investment manager is responsible for deploying the fund’s assets across a diverse array of assets, including stocks, bonds, and other securities. Everyone makes a big deal about fees, but how much do they really impact your investments? Let’s run the numbers to see how an actively managed mutual fund can outperform a typical S&P 500 index fund—even with fees. 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.

Index funds may also be structured as exchange-traded funds, or ETFs. There are some subtle differences between ETFs and index funds that are structured as mutual funds. An exchange-traded fund, as the name implies, is traded on a stock exchange in the same way as a stock. Investors can buy and sell shares of an ETF throughout the day, and shares will likely be available to purchase through any broker you choose. One feature of mutual funds is that you can always buy fractional shares.

While fractional shares of other securities are becoming common, it’s actually a feature supported by individual brokers and not the securities themselves. You’ll always be able to acquire fractional shares of a mutual fund, which makes it convenient for someone looking to ensure all their money is invested or invest small amounts. A stock is listed on an exchange, and investors can buy or sell shares at any time. Any broker will have access to the major exchanges, and you’ll be able to place a trade for a stock through your broker of choice.

We do not manage client funds or hold custody of assets, we help users connect with relevant financial advisors. SmartVestor shows you up to five investing professionals in your area for free. From the hallowed pages of the Wall Street Journal to the watery depths of TikTok, every financial “expert” has an opinion on the issue. Over a long-enough period, investors might have a better shot at achieving higher returns with an index fund.

Their goal is to beat the average market returns for their investors. An index fund’s sole purpose is to provide investors with exposure to a certain asset class. That could be large-cap U.S. stocks through a simple S&P 500 index fund.

The Keys to Becoming a Successful Investor

Over the course of 30 years, the additional 0.53% in fees paid for the actively managed fund would cost you $227,416.16, assuming both funds continued to return 10% per year. The index fund charges the industry-average expense ratio of 0.13%. Studies have shown there are very few fund managers who can beat the market over the long term, especially when adjusting for fees. There are funds for almost any investment strategy and goal, including international investing, emerging markets, investing in a specific sector, socially responsible investing, and more.

If you choose active management, particularly when the overall market is down, then you might have the opportunity to make higher returns, at least in the short term. Mutual funds require a portfolio manager and support staff to keep things going — which come at a cost of typically higher MERs. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on, top-rated podcasts, and non-profit The Motley Fool Foundation. If you’re ready to get started, check out the SmartVestor program. We can connect you with up to five investment professionals to choose from.

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