Index Funds vs. Mutual Funds: Which Is Best?

It’s not uncommon to see beginning investors dip their toes in a pool of investments known as mutual funds. Mutual funds can be categorized by what they invest in, such as money markets, bonds, stocks or target-date funds.

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Funds also can be categorized by the investment style used to choose those investments. This guide covers both index funds and mutual funds. Understanding the difference between these two funds and investment styles can help investors choose the right funds for their portfolios.

What Is a Mutual Fund?

A mutual fund is a collection of assets pooled together into a single fund that you can invest in. Actively managed mutual funds rely on the expertise and research of individuals who choose how to invest the money.

What Is an Index Fund?

There’s no structural difference between a mutual fund and an index fund. An index fund is simply a passively managed mutual fund that tracks a certain index, such as the S&P 500.

Index Funds vs. Mutual Funds

If you’re choosing between index funds and mutual funds, you’ll want to consider a few factors. Here’s how they compare.

Investment Goals

The biggest difference between actively managed mutual funds and passively managed index funds is their objectives.

With an actively managed mutual fund, the company that runs the mutual fund has a fund manager and a team of researchers making all the investment decisions. The fund manager’s goal is to outperform the market. However, there’s always a risk that the fund will underperform the market. Investors simply buy into the fund and either see their investments go up or down, depending on the fund’s performance — that is, the performance of the stocks selected by the fund manager for inclusion in the mutual fund.

Index funds, on the other hand, are structured to match the losses or gains of the index they track. No one picks the investments within the fund. Instead, the fund automatically invests in a representative sample of the stocks and bonds in the index it tracks, so it’s looking to match the market rather than beat it. So if you have an S&P 500 index fund, that fund should increase or decrease in value by the same amount as the S&P 500 every day. This is because the fund owns stocks that are on that index.

Risk Level

Index funds and mutual funds both are less risky than individual stocks. The reason is that each has a collection of stocks, which adds diversification to portfolios — an important factor for investors. However, actively managed funds could have a risk advantage when the market is down because fund managers have more flexibility in terms of the stocks they buy and sell for the fund. Index fund managers have fewer options because they have to stick mostly with stocks in the index in order to track the index, even when it’s falling.

Performance

Ironically, index funds usually perform better than actively managed mutual funds. Few actively managed funds beat the market in any given year, and even fewer outperform their benchmarks over the long term, according to the Financial Industry Regulatory Authority.

In fact, Morningstar analyzed over 8,300 funds last year to compare actively and passively managed funds. The resulting “Morningstar’s US Active/Passive Barometer” report noted that just 47% of actively managed mutual funds “survived and beat” their average passive equivalents in 2022, and less than 25% survived and beat their average passive equivalents over 10 years. The worst results came from U.S. large-cap mutual funds, which have the same types of stock you find in an S&P 500 index fund.

Actively managed funds’ weaker performance illustrates why so many experts recommend index funds — even professional fund managers struggle to select stocks that consistently beat the market.

Cost

Funds are cost-efficient, giving investors access to the broader market without having to put up large sums of cash to buy numerous individual stocks. But you’ll likely pay higher fees if you opt for an actively managed mutual fund over an index fund.

The fees for an index fund or mutual fund are expressed as an expense ratio. Expense ratios indicate how much of a fund’s assets are spent on expenses such as management and advertising. The percentage is usually higher for actively managed funds because of the cost of employing a full-time manager as well as the cost of executing frequent trades.

When comparing costs of different funds, it’s important to look not just at the expense ratios, but also at what those ratios mean for the funds’ returns. A fund that returns 9% a year and has an expense ratio of 0.20% is a better value than a fund that returns 10% a year but has an expense ratio of 1.50%.

Regardless of which type of fund you choose, you should expect to pay an annual fee and other expenses beyond those included in the expense ratio. For example, some funds charge sales loads, which are commissions paid to the brokers, and you might also pay fees to purchase or redeem your shares.

FINRA offers a Fund Analyzer that helps you compare the cost of owning funds.

Tax Efficiency

No matter how they’re managed, most funds are subject to capital gains tax. But you’ll likely pay more tax with an actively managed fund. That’s because capital gains tax is triggered when the fund manager sells stock at a profit. That profit, or gain, gets distributed to investors, who then pay capital gains tax on the distribution. Actively managed funds trade more often, so they usually distribute more taxable gains compared to an index fund.

Index funds also have an edge because of the size of their trades. As The Wall Street Journal explained, index fund managers often trade small numbers of shares to stay in line with the index they’re tracking. If a large number of investors redeem their shares — i.e., divest — and the fund managers need to sell shares to cover the redemptions, they can sell the pools of stocks purchased at higher prices, which generates less capital gains.

Which Is Better: Index Funds or Mutual Funds?

Index funds and actively managed mutual funds can both be excellent options for investing, especially if you’re a retirement investor looking for a simple way to make safe investments.

Here’s another look at how the two compare on a variety of factors likely to impact your investment decision:

• Risk: Actively managed funds win this category. Whereas index fund managers’ hands are tied when it comes to selecting stocks, managers of actively managed funds have more flexibility for trading shares when markets are declining.

• Performance: Passive funds win this category. Despite — or perhaps because of — their ability to handpick stocks, three-quarters of active funds miss their benchmarks over the long term.

• Cost: Passive funds win on this metric as well. Active management is costly in terms of the expenses involved in the trades themselves as well as the cost of paying full-time managers. What’s more, higher costs mean actively managed funds have to perform better than index funds to generate the same returns for investors.

• Tax efficiency: Passive funds are the clear winner when it comes to taxes. Fewer trades overall, and the ability to leverage small trades to reduce capital gains, make index funds more tax-efficient.

That said, in plenty of situations, actively managed mutual funds could be a better investment for a particular investor — especially those that consistently outperform the major indexes. Always examine each investment decision in the context of your portfolio and your financial goals.

For example, your specific circumstances might call for a particular fund. If you’re looking for a way to grow your money quickly, keep an eye on aggressive mutual funds with a proven track record of beating the market by high percentages.

Index Funds vs. Mutual Funds: Which One Is Right for You?

If you’re interested in taking an active approach to investing, mutual funds might be the better choice if you select high-performing, low-cost funds, which are the type most likely to outperform their benchmarks, according to Morningstar. But if you are fairly new to investing, consider low-cost index funds that track major indices like the S&P 500, Dow Jones or Nasdaq. It’s an easy way to make a solid investment that will help you grow your wealth.

Joel Anderson contributed to the reporting for this article.

This article has been updated with additional reporting since its original publication.

This article originally appeared on GOBankingRates.com: Index Funds vs. Mutual Funds: Which Is Best?