The primary difference between index funds and mutual funds is that index funds invest in a basket of securities that aim to mirror the performance of a specific index (such as the S&P 500), whereas active mutual funds invest in a continually changing list of investments, as selected by an investment manager.
Over a long enough period, investors might have a better shot at achieving higher returns with an index fund. Exploring differences between the two investment types reveals why.
Index fund vs. mutual fund at a glance
|
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%. |
0.64%. |
|
Brokerage firms |
|
|---|---|
on Charles Schwab’s website |
on E*TRADE’s website |
on Vanguard’s website |
on Fidelity’s website |
Differences between mutual funds and index funds
When choosing between these funds, you’ll want to consider how their management styles, investment strategies and costs differ.
1. Passive vs. active management
Because no one is actively managing the portfolio, performance is based solely on the price movements of the individual stocks in the index, rather than someone trading in and out of stocks. This is why index investing is considered a passive investment 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.
The sole objective of an index fund is to mirror the performance of the underlying index. But the objective of an actively managed mutual fund is to outperform the index — that is, to earn higher returns by having experts pick investments they think will beat the market.
That being said, there are some fund managers that do beat the market. The scorecard says that in the past year, 34.76% of funds have outperformed the market.
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 diversify your portfolio a bit more by buying value stocks or asset weighting toward other companies.
But in exchange for potential outperformance, 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.
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.
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. However, the higher fees investors pay are directly deducted from the returns they receive from the fund, leading many actively managed mutual funds to underperform.
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 double-whammy, and the price can run high.
Index funds also tend to be more tax-efficient; however, some mutual fund managers incorporate tax management into their strategies, which can sometimes offset the differences.
