Index funds and mutual funds can help investors build diversified portfolios. Understanding the difference between the two is often challenging — even more so due to the fact that index funds are actually mutual funds.
In fact, index funds are a type of passively managed mutual fund or ETF constructed to match or track the components of a financial market index. The majority of other mutual fund types are actively managed by investors that pool money to trade a variety of securities.
Understanding the similarities and differences between these investment types can help you decide which is the best option for you.
At a Glance: Index Funds vs. Mutual Funds
The main difference between mutual funds vs. index funds is the way they are managed. Mutual funds are typically passive investments, whereas investors manage index funds actively.
Beyond this, there are many other factors that set apart the index from mutual funds.
| Factors | Index Funds | Mutual Funds |
| Investment goal | Track and match the investment returns of a benchmark stock index. Do not deviate their holdings from that particular index | Outperform the investment returns of a related benchmark stock index. Deviates from the benchmark and invests in a variety of stocks |
| Traded securities | Stocks, bonds, and other types of securities | Stocks, bonds, and other types of securities |
| Investment horizon | Short to mid-term | Long-term |
| Performance | Typically outperform mutual funds | Lower performance compared to index funds |
| Average fees and costs | 0.1% of assets under management | Up to 2% of assets under management |
Both index funds and mutual funds trade the same type of securities, but the former is a closed-ended investment type that tracks and matches the investment return of a benchmark stock index, such as the S&P 500.
Because the fund follows an index, it is passively managed and incurs lower fees compared to mutual funds.
Mutual funds can and typically deviate from the benchmark index. They are actively managed by their investors and can include an array of assets. In this aspect, they are similar to ETFs.
The goal of mutual fund investments is to outperform the related benchmark index. In reality, however, they have lower performance than trustworthy index funds.
This doesn’t mean that index funds are risk-free. On the contrary, investing in a poor index could result in crummy returns and even losses.
Index Funds vs. Mutual Funds — Overview
For many investing beginners, the idea of hand-picking securities can seem daunting. That step is not necessary with mutual and index funds. However, each option comes with its own pros and cons.
What Are Index Funds
An index fund is a pool of investments that aims to mimic the performance of a certain benchmark index. The benchmark index can be S&P 500, FTSE All-Share Index, NASDAQ Composite, etc.
Investors buy shares in the fund and see gains when those shares grow in value.
Because the fund mimics the market movements of a specific benchmark index, investors don’t have to select individual investments in their portfolio, and the fund is managed passively. This could make it an excellent option for beginners with little knowledge of investing.
Pros and Cons of Index Funds
Index Funds Advantages
✔️ Diversification. Index funds are made up of an array of assets, reducing your risks as an investor.
✔️ Requires little financial knowledge. As explained, index funds are managed passively. Investors with little financial knowledge can still build a strong portfolio by simply selecting a trustworthy index fund.
✔️ May outperform mutual funds. Unlike mutual funds, which are picked manually, index funds contain hundreds of stocks that can be hard to replicate at an individual level. When investing in the best indexes, such as FTSE All-Share, an index fund is likely to return higher gains than a mutual fund.
✔️ Low investment management cost. Because they are based on an index, index funds are cheaper to own than mutual funds and other actively managed investments. Typical average fees are under 0.5% of assets under management.
✔️ Lower taxes. Similar to mutual funds, index funds can create lower tax liabilities compared to other investment types.
Index Funds Disadvantages
❌️ Lack of downside protection. Stock indexes can experience a great deal of volatility, and the absence of an active manager means that no one can hedge the portfolio or move positions to cash and limit the downfall.
❌️ Performance is dependent on the selected index. While index funds can outperform mutual funds, this is only true when investing in established and trustworthy indexes. This is why beginners should consult a financial planner or investment manager before buying shares in a fund.
❌️ Deliver average returns. Even though indexes have a higher performance than mutual funds, they have lower returns compared to individual stocks. That’s because index funds invest in all securities in the fund, so it’s impossible to avoid the losers.
What Are Mutual Funds
Mutual funds are investment types that let you pool money with other investors and trade securities such as stocks, bonds, or short-term debt.
There are various types of mutual funds, including:
- Stock funds. This category includes all types of corporate stocks and can be divided into growth funds, income funds, and sector funds. Index funds also fall into this category.
- Bond funds. Like stock funds, bond funds include a variety of bond types. Risks and rewards can vary dramatically from bond to bond.
- Money market funds. Ideal for investors looking for a lower-risk option, money market funds can only invest in certain shares issued by local governments or government-approved corporations.
- Target date funds. Similar to ETFs, they hold a variety of stocks, bonds, and other security types. They are designed for investors with a particular retirement date in mind.
Pros and Cons of Mutual Funds
Mutual Funds Advantages
✔️ Opportunity for outperformance. As active funds, mutual funds aim to beat an index and offer investors the potential to make higher returns than benchmarks.
✔️ Diversification. Similar to index funds, mutual funds invest in a range of companies and industries.
✔️ Defensive measures. Fund managers have the ability to respond tactically to market opportunities or downsides. They can sell securities and change market environments, minimising losses.
✔️ Tax management opportunities. Even though mutual funds are not as tax efficient as index funds, some managers could harvest some losses to maximise taxable distributions of capital gains. In this aspect, mutual funds can be more tax efficient than individual stocks.
✔️ Affordability. Most mutual funds are relatively affordable to set up an initial investment.
✔️ Quicker access to liquidity. Mutual fund investors can redeem their shares at any time. While most funds have redemption fees in place, you can still convert shares into liquidity whenever necessary.
Mutual Funds Disadvantages
❌️ Expensive in the long run. Mutual funds are affordable for an initial investment but more expensive to manage than index funds. Average costs and fees can go up to 2% of assets under management.
❌️ Risks of underperformance. Historically, mutual funds have had a lower performance than their benchmarks.
❌️ Capital gains distribution. When investing, you don’t have to pay taxes on dividends that have not been cashed out. However, mutual fund managers may have to put out certain capital gains for tax purposes, making all investors liable for capital gains tax even though they haven’t sold a single share of their fund.
❌️ Active risks. Due to the active management, mutual funds are riskier than index funds. The manager could choose a poor investment, causing the entire fund to underperform.
When to Invest In Index Funds vs. Mutual Funds
There is no foolproof method to decide when it’s best to invest in index vs. mutual funds. However, the market conditions at the moment of investing could help you decide which investment to choose.
Investing in index funds is a wise idea during strong bull markets when stock prices are rising across most sectors. In a stable market, mutual funds can lose their advantage, as the strategic buying and selling of actively managed funds have about the same chances of losing to major market indexes as an index fund.
However, index funds lose to actively managed funds when markets turn volatile.
During bear markets, a skilled manager can find the stocks or bonds that can outperform major market indices. Experienced managers can also identify those sectors or industries that thrive in periods of economic uncertainty, increasing investment returns.
Top Trading Apps for Index and Mutual Funds
Whether you want to invest in index or mutual funds, starting on a trading app can help you gain experience and build confidence.
1. Vanguard
Suitable for investors of all levels, Vanguard is a trading platform based on a traditional approach to investing.
When signing up for Vanguard services, you sign up for investment portfolios developed by professional teams.
The app claims to reduce the risk of losing money from market swings, but is a better choice for long-term investments.
That said, the service has been endorsed by experts such as Warren Buffett. While it might not be appealing if you dream of fast returns, investing through them can secure significantly greater amounts of money in terms of liability and better ROIs than the average market growth.
2. eToro
Ideal for beginners, eToro can help you learn the ins and outs of trading by mimicking the moves of its top-performer traders.
But this is not the only reason to sign up. The app charges low commissions and fees, and you can start with a low initial deposit.
Inside the app, you can set the desired level of risk tolerance and invest in a broad range of stocks.
eToro’s smart portfolios also enable you to invest in index funds, ETFs, and more.
eToro is a multi-asset investment platform. The value of your investments may go up or down. Your capital is at risk.
Conclusion
Index funds are a type of passively managed mutual funds. They follow specific market indexes and can earn an average return to investors.
A mutual fund is a term commonly used to designate active investments managed by a broker or investment manager. Mutual funds are a better investment choice in periods of economic decline. However, during bull markets, your best bet is an index fund.
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