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

what is the difference between mutual fund and index fund

Because it’s deducted directly from an investor’s annual returns, that leaves less money in the account to compound and grow over time. We are an independent, advertising-supported comparison service. ETFs are attractive to many people since their MERs  are often significantly lower than those of mutual funds. In most cases, buying an ETF is easier than buying a mutual fund or index fund. That’s because ETFs are bought on an open exchange, whereas mutual funds and index funds are priced at the end of the day.

what is the difference between mutual fund and index fund

Here are the most important ones for investors to know before they decide which is best for them. Mutual funds appeal to some people because of their active management. The thinking is that a higher MER is justified if the fund managers are consistently able to outperform the indexes. While there is some truth to that strategy, history has shown that passive investing often outperforms active investing, and it’s likely that trend will continue[1]. All three funds are typically managed by professionals, so little effort is required on your end. All of the buying and selling of individual securities is done by the fund managers or algorithms.

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. These funds are managed by professional portfolio managers who decide trades based on the fund’s objectives. While some mutual funds track an index, known as index funds, not all mutual funds follow this strategy. Therefore, while index mutual funds fall under the mutual funds’ umbrella, not all are structured to mirror market indices. Since actively managed funds require a portfolio manager and a team of researchers to feed information about investment decisions, they charge higher expense ratios than index funds.

Investment Risks

This highlights that even though the market has experienced high volatility in the last few years, active funds don’t necessarily yield better performing funds. A mutual fund company collects inflows and outflows of investors’ money throughout the day. Although it’s unlikely you’ll beat the market by investing in an ETF or index fund, you’ll probably get average returns, and may eventually come out ahead. ETFs and index funds typically use a passive style of investing.

  1. Actively trading an index fund also doesn’t make a lot of sense, either.
  2. Conversely, actively managed mutual funds incur higher fees due to the active trading, research and management involved.
  3. 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.
  4. Index funds aren’t a separate investment vehicle from mutual funds.
  5. Unlike a mutual fund, an ETF has a value that fluctuates on a public exchange throughout a trading session.

NerdWallet, Inc. is an independent publisher and comparison service, not an investment advisor. Its articles, interactive tools and other content are provided to you for free, as self-help tools and for informational purposes only. NerdWallet does not and cannot guarantee the accuracy or applicability of any information in regard to your individual circumstances. Examples are hypothetical, and we encourage you to seek personalized advice from qualified professionals regarding specific investment issues. Our estimates are based on past market performance, and past performance is not a guarantee of future performance. Index funds may also be structured as exchange-traded funds, or ETFs.

Therefore, there is no need to buy and sell securities regularly. This is one of the biggest differentiators of index funds vs. mutual funds. This requires the fund manager to make daily or even hourly trading decisions.

Kat has expertise in insurance and student loans, and she holds certifications in student loan and financial education counseling. By contrast, index funds are passively-managed and designed to match their index’s performance as closely as possible. We do not manage client funds or hold custody of assets, we help users connect with relevant financial advisors.

What are mutual funds?

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.

An index fund is by its nature a passively managed investment, so you’re buying the index to get its long-term return. If you trade in and out of the fund, even if it’s a low-cost ETF, you may easily lower your returns. Imagine selling in March 2020 as the market crumbled, only to watch it skyrocket over the next year.

Remember, the lower the management fees, the more the shareholder can receive in returns. Most mutual funds, which often carry minimum balance requirements, fall into one of four categories. We believe everyone should be able to make financial decisions with confidence. An index fund can be structured as a mutual fund, in which case you’ll buy and sell shares in the same way you would for any mutual fund. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer.

Mutual funds are actively managed, index funds are passively managed.

If you’re trading in and out of the fund, you’re second-guessing professional investors that you’ve effectively hired to invest your money. That doesn’t make a lot of sense, and it can ring up capital gains taxes, if the fund is held in a taxable account, as well as fees for early redemption of your mutual fund. Both index funds and mutual funds can help you achieve your financial goals, but through very different approaches. With one, you’ll enjoy passive, hands-off investing that offers steady returns. With the other, you’ll get an actively managed fund that could, in some cases, beat the market.

Before you decide between index funds vs. mutual funds, consider your investment goals and risk tolerance. Working with an adviser may come with potential downsides such as payment of fees (which will reduce returns). There are no guarantees that working with an adviser will yield positive returns. The existence of a fiduciary duty does not prevent the rise of potential conflicts of interest. They’re bundled into a fee that’s called the mutual fund expense ratio. As you can imagine, it costs more to have people running the show.

When Does It Make Sense to Invest in Index Funds?

According to 2020 data, the S&P 500 returned 13.6% annually over the last 10 years.

Index funds are passively managed—which means the fund simply buys shares of stocks that are included on the index it’s based on instead of relying on a team of experts to pick the stocks. A mutual fund is a fund that pools money from lots of investors and buys a portfolio of securities designed to meet a goal. That goal is usually to outperform a benchmark index by selecting stocks, bonds, and other securities the fund manager believes will produce outsized returns. The major differences between mutual funds and index funds are the management style and fees. Mutual funds are actively managed, whereas index funds use a passive approach.

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