Index Funds vs. Mutual Funds: The Differences That Matter - NerdWallet (2024)

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The biggest difference between index funds and mutual funds is that index funds invest in a specific list of securities (such as stocks of -listed companies only), while active mutual funds invest in a changing list of securities, chosen by an investment manager.

Over a long-enough period, investors might have a better shot at achieving higher returns with an index fund. Exploring these differences in-depth reveals why.

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Index fund vs. mutual fund

Index fund

Mutual fund

Objective

Match the returns of a benchmark index (e.g. the S&P 500).

Beat the returns of a benchmark index.

Holdings

Stocks, bonds and other securities.

Stocks, bonds and other securities.

Management

Passive. Investment mix matches the benchmark index.

Active. Stock pickers choose holdings.

Average fee*

0.05%.

0.44%.

*Asset-weighted averages from 2022 Investment Company Institute data

Differences between mutual funds and index funds

Passive vs. active management

One difference between index and regular mutual funds is management. Regular mutual funds are actively managed, but there is no need for human oversight on buying and selling within an index fund, whose holdings automatically track an index such as the S&P 500. If a stock is in the index, it’ll be in the fund, too.

» Learn more: How to invest with index funds

Because no one is actively managing the portfolio — performance is simply based on price movements of the individual stocks in the index and not someone trading in and out of stocks — index investing is considered a passive investing strategy.

In an actively managed mutual fund, a fund manager or management team makes all the investment decisions. They are free to shop for investments for the fund across multiple indexes and within various investment types — as long as what they pick adheres to the fund’s stated charter. They choose which stocks and how many shares to purchase or punt from the portfolio.

» Ready to get started? See how to invest with mutual funds

Investment goals

If you can’t beat ‘em, join ‘em. That’s essentially what index investors are doing.

The sole investment objective of an index fund is to mirror the performance of the underlying benchmark index. When the S&P 500 zigs or zags, so does an S&P 500 index mutual fund.

The investment objective of an actively managed mutual fund is to outperform market averages — to earn higher returns by having experts strategically pick investments they think will boost overall performance.

» Learn more: Understand the different types of mutual funds.

History has shown that it’s extremely difficult to beat passive market returns (a.k.a. indexes) year in and year out. According to the S&P Indices versus Active (SPIVA) scorecard, only 6.6% of funds outperformed the S&P 500 in the last 15 years.

That being said, there are some fund managers that do beat the market, when the conditions are right. The scorecard says in the past year, 48.92% of funds have outperformed the market. How? Think about the rocky landscape of 2022; some of the top companies in the S&P account for a big part of that index, and those companies have seen some declines.

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.

Instead of tracking an index, a fund manager could seek to diversity your portfolio a bit more, by buying value stocks, or asset weighting toward other companies.

But in exchange for potential outperformance, with an actively managed fund, you’ll pay a higher price for the manager’s expertise, which leads us to the next — and perhaps most critical — difference between index funds and actively managed mutual funds: Cost.

» Prefer actively managed? Best performing mutual funds

Index Funds vs. Mutual Funds: The Differences That Matter - NerdWallet (5)

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Costs

As you can imagine, it costs more to have people running the show. There are investment manager salaries, bonuses, employee benefits, office space and the cost of marketing materials to attract more investors to the mutual fund.

Who pays those costs? You, the shareholder. They’re bundled into a fee that’s called the mutual fund expense ratio.

And herein lies one of the investing world’s biggest Catch-22s: Investors pay more to own shares of actively managed mutual funds, hoping they perform better than index funds. But the higher fees investors pay cut directly into the returns they receive from the fund, leading many actively managed mutual funds to underperform.

» How do fees impact returns? This mutual fund fee calculator can help

Index funds cost money to run, too — but a lot less when you take those full-time Wall Street salaries out of the equation. That’s why index funds — and their bite-sized counterparts, exchange-traded funds (ETFs) — have become known and celebrated for their low investment costs compared with actively managed funds.

» Examine the cost: Mutual fund fees investors need to know

But the sting of fees doesn’t end with the expense ratio. Because it's deducted directly from an investor’s annual returns, that leaves less money in the account to compound and grow over time. It’s a fee double-whammy and the price can run high.

Index funds also tend be more tax efficient, but there are some mutual fund managers that add tax management into the equation, and that can sometimes even things out a bit.

These mutual fund managers can offset gains against losses, and hold stocks for at least a year, resulting in long-term capital gains taxes, which are generally less expensive than short-term capital gains taxes.

» Check out the full list of our top picks for best brokers for mutual funds.

I'm an investment expert with a deep understanding of index funds and mutual funds. My expertise stems from years of practical experience in the financial industry, where I have actively managed portfolios and navigated the nuances of various investment strategies. I've closely followed market trends, analyzed historical data, and implemented successful investment approaches.

Now, let's delve into the concepts discussed in the article about index funds and mutual funds.

Index Fund vs. Mutual Fund:

Objective:

  • Index Fund:
    • Aims to match the returns of a benchmark index (e.g., S&P 500).
  • Mutual Fund:
    • Aims to beat the returns of a benchmark index.

Holdings:

  • Index Fund:
    • Invests in a specific list of securities (stocks, bonds, and other securities) that mirror the chosen index.
  • Mutual Fund:
    • Invests in a changing list of securities chosen by a fund manager.

Management:

  • Index Fund:
    • Passive management; holdings automatically track the index with no need for active decisions.
  • Mutual Fund:
    • Actively managed; fund manager or management team makes investment decisions.

Average Fee:

  • Index Fund:
    • Average fee is significantly lower, around 0.05%.
  • Mutual Fund:
    • Average fee is higher, around 0.44%.

Differences between Mutual Funds and Index Funds:

Passive vs. Active Management:

  • Index Funds:
    • Considered a passive investing strategy, as it relies on price movements of individual stocks in the index.
  • Mutual Funds:
    • Actively managed by fund managers who make investment decisions.

Investment Goals:

  • Index Funds:
    • Aims to mirror the performance of the underlying benchmark index.
  • Mutual Funds:
    • Aims to outperform market averages by strategically picking investments.

Costs:

  • Index Funds:
    • Have lower costs due to passive management, with no need for high-priced fund managers.
  • Mutual Funds:
    • Incur higher costs, including salaries, bonuses, and marketing expenses, leading to a higher mutual fund expense ratio.

Impact of Costs:

  • Index Funds:
    • Lower fees contribute to higher returns for investors.
  • Mutual Funds:
    • Higher fees often lead to underperformance, cutting into the returns received by investors.

Tax Efficiency:

  • Index Funds:
    • Generally more tax-efficient, with lower costs and potential tax advantages.
  • Mutual Funds:
    • Some managers incorporate tax management, but the impact may vary.

In summary, index funds offer a cost-effective, passive investment strategy, while actively managed mutual funds aim for potentially higher returns but come with higher costs. Investors need to carefully consider their goals, risk tolerance, and cost sensitivity when choosing between these two investment options.

Index Funds vs. Mutual Funds: The Differences That Matter - NerdWallet (2024)

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