Index funds vs. mutual funds: Understanding both.

Both include a pool of many different stocks and offer a way to diversify and protect your investments. In fact, most index funds are a type of mutual fund. The main difference is that index funds are passively managed, while most other mutual funds are actively managed, which changes the way they work and the amount of fees you’ll pay.

What is an index fund?

An index fund is a type of investment that attempts to track the overall success of a particular market or index, like the S&P 500 or Dow Jones Industrial Average. They do this by offering small pieces of most or all of the stocks in an index, pooled together. Index funds make diversification much easier for the average investor, and the passive management style allows the manager to charge lower investment advisory fees. 

Investing in index funds is often referred to as passive investing, because index funds operate without much human intervention. You don’t need to research individual companies and make selections based on which stocks you think are likely to overperform. If the overall market grows, your investment is likely to follow the market. It’s a good way to invest for retirement without putting in a lot of additional effort. Both index funds and mutual funds are sold by prospectus; investors should always read the prospectus carefully before investing.

Pros and cons of index funds.

Index funds are seen as less volatile investments because they are more diversified than an investment in individual stocks. Diversification is a strategy for spreading risk. Many investment strategists believe index funds should be a core component of a retirement portfolio. Because they don’t require active management, the fees and the expense ratios of index funds tend to be lower, which means they can often outperform higher-cost funds, even without beating them. Still, they aren’t without risk, and there are a few drawbacks. Index funds give you less control than other types of investments. The investment return and principal value of an index fund will fluctuate. Index funds will be subject to the same special risks as the securities making up the index.

Index fund benefits:

• Diversification
• Low operating expenses
• Good long-term outlook
• Potentially lower taxes

Index fund drawbacks:

• Lower flexibility and choice
• Steady, but potentially lower, gains

How do I choose an index fund?

While there are hundreds of options available from different investment firms, index funds that track the same index will have fairly similar returns. There should be plenty of index fund options wherever you select your investments, whether it’s an online brokerage or within your 401(k). The most popular index to track is the Standard and Poor’s 500 index (S&P 500).

Are index funds mutual funds?

Sometimes. Index funds are often a type of mutual fund, but they can also be exchange-traded funds (ETFs). There are differences in how mutual funds and ETFs work, and their fees and market price may differ. But these aren’t as important to everyday investors as which index the investment tracks.

What is a mutual fund?

A mutual fund is a type of investment that pools separate investors’ money into a large basket. A fund manager makes investment decisions with the entire amount, based on the goal of the fund. The gains and losses are then shared with everyone invested in the fund.

Like index funds, mutual funds are popular because they give individual investors a way to instantly diversify their investments, even if they have only a small amount to invest. Instead of purchasing stock in one or two companies, you can indirectly invest in hundreds.

Actively managed funds vs. passively invested funds.

While index funds are passive, most mutual funds are actively managed. That means individuals or companies are making decisions based on what they believe will create the best return for all the investors. A more active investment management style will generally be associated with higher fees than are involved with a passive index style. The fees are generally expressed as an “expense ratio.” Basically, you’re paying a little more for the manager’s expertise and knowledge of the markets. This can be great when the manager makes good decisions. It’s not so good when the decisions are average or even poor. Therefore, it’s important to do your research and check the historic growth of the mutual funds you’re considering.

Pros and cons of mutual funds.

As with any other investment, you must balance many factors in deciding if a mutual fund is right for you. Any two mutual funds can be very different, but here are a few general aspects to keep in mind as you build your personal investment strategy:

Mutual fund benefits:

• Diversified portfolio
• Low minimum investment requirement
• Professionally managed
• Liquidity: Shares can be redeemed on any business day at their current net asset value, which may be more or less than their original cost.
• Large variety of choices

Mutual fund drawbacks:

• Fees and expenses
• Comparing funds can be difficult

How do I choose a mutual fund?

Mutual funds come with a variety of objectives and strategies, and there are many more options than with index funds to customize how you want to invest. While one fund may focus on large-cap energy companies, another may look specifically for start-ups with potentially high growth. One may include hundreds of companies’ stocks, and another may include only a few. Each will have different strategies and risk profiles. For that reason, researching mutual funds is a little more involved than researching index funds. Learn more about the types of mutual funds you can invest in.

Major differences between mutual funds and index funds.

While similar, there are some very important differences between index funds and non-index mutual funds. The most important difference is that index funds are passively managed, while non-index mutual funds are actively managed by a professional. Both are incredibly popular investment vehicles, because they usually offer more diversification than can be achieved by purchasing individual stocks. However, they provide different levels of diversification, different fee structures, and different tax advantages. Here are a few other differences between index funds and non-index mutual funds:

How are index funds and mutual funds the same?

For most investors, both non-index mutual funds and index funds can offer the type of diversification that helps investors spread risk over many investments. With any investment, there is always the risk of a loss. It’s possible to start investing in index funds and non-index funds with a low minimum investment, which can help investors without significant savings get started.

How are index funds and mutual funds the same?

For most investors, both non-index mutual funds and index funds can offer the type of diversification that helps investors spread risk over many investments. With any investment, there is always the risk of a loss. It’s possible to start investing in index funds and non-index funds with a low minimum investment, which can help investors without significant savings get started.

Which is better, index funds or mutual funds?

People’s risk tolerance, investment styles, and strategies are different. Decisions can be further affected by your age, your current savings, and your passions. Plus, a huge number of investment options. Generally, if you want to “set it and forget it,” index funds are a good bet. If you want the potential upside of a professionally managed fund or want to show your support for specific industries, like renewable energy, actively managed mutual funds will give you more options. Ultimately, since index and mutual funds have a lot of variety, it’s hard to say what may be right without getting to know you individually. Fortunately, our agents are well versed in the options and can help you decide where to take your investment portfolio. Connect with us, and we’ll help you make your next move.

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