Mutual Funds vs Index Funds: Which is Better?

A mutual fund pools money from many investors and uses that money to buy a range of securities including stocks, bonds and other assets. Mutual funds are typically managed by a professional fund manager that buys and sells securities in line with the goals of the mutual fund.

The goal of a mutual fund is to outperform the standard return of the stock market. This is why a professional fund manager tries to buy, sell and hold investments that will increase the likelihood that that will happen.

An index fund is a type of mutual fund that tracks the performance of a specific market benchmark, such as the S&P 500, as closely as possible. The goal of an index fund is to provide returns that are similar to that of the index the fund is tracking. Unlike a mutual fund, an index fund is not actively managed by a professional fund manager.

Instead, an index fund simply buys stocks of the underlying index. A stock market index is simply a measurement for the stock market, or sector of the stock market. For example, the S&P 500 is an index that tracks the performance of the 500 most important companies in the US. Therefore, when you buy an S&P 500 index fund, you are buying the stocks of the 500 most important companies in the US.

1) Instant diversification: Both mutual funds and index funds offer instant diversification. In other words, mutual funds and index funds invest in many different stocks and securities at the same time. This means that your exposure to risk is lower than it would be if you bought just one stock.

For example, say that you had invested all of your money in Tesla. If Tesla's stock goes down in value, your entire investment portfolio goes down. However, say you have bought a fund that had Tesla stock, but also had the stocks of dozens or hundreds of other good companies. If Tesla goes down in value, the other stocks in the fund can make up for it.

This makes investment funds inherently less risky than investing in individual stocks. It is one of the main reasons that mutual funds and index funds have grown to be so popular.

2) Easy to invest in: Both mutual funds and index funds are easy to invest in. There are quite literally thousands of funds that you can choose from. Investment funds eliminate the need to have to choose a selection of individual stocks as the fund does that for you.
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3) Affordable: Considering that you get an entire basket of investments, mutual funds and index funds are affordable investments. Index funds and mutual funds charge what is called an expense ratio. This is just a fancy term for the fee that the fund charges.

A reasonable expense ratio for an actively managed mutual fund would be between 0.5% and 1% per year. This means you would pay a $0.50 to $1 fee on every $100 you invested per year. A reasonable expense ratio for an index fund would be 0.2% or less. This means that you would pay a $0.20 fee on every $100 you invested per year.

1) Management style: The main difference between mutual funds and index funds is the way that they are managed. Mutual funds are managed actively. All this means is that a team of financial experts actively tries to find the best stocks and assets available for the fund.

On the flipside, index funds are passively managed. This simply means that index funds don't require a team of financial experts to pick stocks. Instead, an index fund copies the investments of the index that the fund is tracking. In other words, index funds have a copy and paste strategy.

2) Mutual fund try to beat the market, index funds try to match the market: The goals of mutual funds and index funds are also different. Since mutual funds are actively managed by financial experts, these experts try to pick a mix of stocks that will beat the standard return of the stock market.

Since index funds are passively managed, they don't try to beat the standard return of the stock market. Instead, they try to match it. Historically, the stock market has provided an average return of around 10% per year over long stretches of time. So, mutual funds try to average a return of more than 10%, and index funds try to average a return of 10%.

3) Index funds cost less: Since mutual funds are managed by investing pros, the fees of mutual funds are higher than index funds since these investing pros need to be paid. However, paying the higher fees of a mutual fund can be a good idea if the mutual fund can outperform the average return of the stock market.

Do mutual funds or index funds perform better?

One of the main things you can consider when deciding between mutual funds and index funds is their performance. In other words, does one typically do better than the other? The short answer is that there are mutual funds that outperform the average return that index funds provide, but it is rare.

According to SPIVA Scorecard Data, over the past 15 years only 6.60% of actively managed mutual funds outperformed passively managed index funds. However, over the past 3 years, 25.73% of actively managed mutual funds outperformed the market.

The point here is that it is very hard for professional fund managers to consistently beat the average return of the stock market over time. In the short term, more fund managers can beat the market, but in the long term only a select few can pull off the feat.

The bottom line is this. There are mutual funds that outperform index funds, but there are very few mutual funds that can consistently do this over time. Also keep in mind that just because a mutual fund has beaten the market in the past, does not necessarily mean that it will do so in the future.

Pros and cons of mutual funds

Pros:

1) Instant diversification which lowers your exposure to risk

2) Actively managed by a team of investing professionals which could mean a higher return

3) Easy to invest in

Cons:

1) Could potentially underperform their benchmark index

2) Higher fees than index funds

Pros and cons of index funds

Pros:

1) Instant diversification which lowers your exposure to risk

2) Lower fees than mutual funds

3) Easy to invest in

Cons:

1) You will only capture the standard return of the stock market

How to decide between mutual funds and index funds

The easiest way to decide between mutual funds and index funds is to compare their performance and cost. If you can find mutual funds that consistently beat the return of the stock market over long periods of time, mutual funds are the way to go. Keep in mind that the return of the mutual fund needs to be high enough to also cover the higher fees that you will pay.

For example, lets say that you are comparing an index fund that averages a return of 10%, with a mutual fund that averages a return of 11.5%. Lets also say that the index fund charges a 0.2% fee and the mutual fund charges a 1% fee.

After fees, the return of the index fund would be 9.8% and the return of the mutual fund would be 10.5%. In this example, it would make sense to invest in the mutual fund since the return covers the higher fee.

However, if you can't find mutual funds that consistently beat the return of the market over long stretches of time, it would be better to invest in index funds. Keep in mind that only 6% of actively managed mutual funds beat the return of index funds over the past 15 years according to SPIVA Scorecard data.

In the short term, a higher percentage of mutual funds can beat the market, but it is hard for mutual funds to replicate this over long periods of time. For this reason, some investors prefer to invest in index funds and take the standard return of the stock market.

Index funds still provide a good return, instant diversification, and have lower costs than mutual funds. If you don't want the hassle of trying to find the select mutual funds that will outperform the stock market over long periods of time, index funds can be a good option.

On a final not, don't feel like you only have to invest in only mutual funds or only index funds. You can mix and match depending upon your goals. If you want to try to capture a higher return, you can place a higher percentage of your investments in mutual funds and a lower percentage in index funds, or vice versa.

Risks of mutual funds

The primary risk you incur from investing in mutual funds is that the mutual fund does not outperform the market and you end up getting a worse return than an index fund. For example, lets say that you expect a mutual fund to provide an average return of 12% over the long haul. Lets also assume that the mutual fund charges a 1% fee.

After subtracting the fee, your return would be 11% per year, which would beat the average stock market return of 10%. However, after you invest in this mutual fund, the return only ends up being 10%. After subtracting out the 1% fee, your true return is 9%. In this example, it would have been better for you to invest in an index fund.

Risks of index funds

The primary risk of investing in index funds is that you could miss out on the potenial higher returns of mutual funds. If you invested all of your money in index funds, but mutual funds provided a higher return, you would end up being worse off.  

Risks of both

Keep in mind that both mutual funds and index funds carry the risk of market volatility. The price of stocks and other assets can go up, down, and sideways. Since mutual funds and index funds are made up of stocks and other assets, the price of these funds can also go up, down, and sideways.

If you invest in a mutual fund and index fund and the fund immediately goes down in value or even crashes, it can be easy to panic. However, this is not what you want to do. Although the value of mutual funds and index funds can fluctuate in the short term, they tend to perform well over the long term.

Lets look at a snapshot of the S&P 500 to prove this. The S&P 500 tracks the performance of the 500 most important companies in the US and is a good indication on how the stock market is doing as a whole.

As you can see, the market has gone up overall during the past 30 years. However, in the shorter time frame there have been significant downturns and crashes. Most recently the financial crash of 2008 and the crash of 2020 due to covid.

The point here is that there is risk to investing in both mutual funds and index funds. However, if you are able to keep a long term perspective and hold on during the downtimes, both mutual funds and index funds tend to recover and perform very well for you as an investor.

Step 1: Open an investment account

Your first step to investing in index funds is to open an investment account. An investment account simply holds your index funds. There are a wide variety of account types availble, but at a bare minimum you will need a brokerage account.

You can open a brokerage account through an online broker. If you need help finding a broker, you can compare our picks for the top online stock brokers here. Once you have chosen a broker, simply go to their website and fill out an application for an account.

Step 2: Research your options

One your account is approved, you can research what index funds you want to invest in. There are tons of index funds available, but it is good to look for well established index funds that have a good track record and low expense ratios (the fees the index fund charges).

One of the most popular types of index funds is an S&P 500 index fund. You can simplify your research by only loooking at S&P 500 index funds. The good news is that almost all online brokers offer free research tools to help you find good index funds.

Step 3: Buy your index funds

Once you have found a few index funds that you want to invest in, you can simply transfer money into your investing account from your bank account and buy your chosen index funds.

Potential index funds to invest in

The Fidelity 500 Index Fund (FXAIX). The Fidelity Zero Large Cap Index Fund (FNILX). The Schwad S&P 500 Index Fund (SWPPX). The Vangaurd S&P 500 ETF (VOO). The SPDR S&P 500 ETF Trust (SPY).

Important note: Keep in mind that these index funds are only examples of what you could invest in and should not be taken as strict financial advice. The index funds that are right for you could be different. We recommend speaking with a licensed financial advisor if you need help choosing index funds.

The process for investing in mutual funds is similar to investing in index funds. Go to an online broker and open an investing account. Research the mutual funds that you want to invest in. Once your investing account is approved, transfer money from your bank account and buy your chosen mutual funds.

Potential mutual funds to invest in

The T. Rowe Price US Equity Research Fund (PRCOX). The Massachusetts Investors Growth Stock Fund (MIGFX). The BlackRock Exchange Blackrock Fund (STSEX). The State Street US Core Equity Fund (SSAQX).

Important note: Keep in mind that these mutual funds are only examples of what you could invest in and should not be taken as strict financial advice. The mutual funds that are right for you could be different. We recommend speaking with a licensed financial advisor if you need help choosing mutual funds.

The bottom line is that both mutual funds and index funds are great investments. Both offer instant diversification, good returns over long stretches of time, are affordable, and easy to invest in. If you can find mutual funds that consistently beat the return of the stock market over long periods of time, mutual funds can be a great option.

However, if you can't consistently find mutual funds that do this, you would be better off investing in index funds. With that being said, you can't really go wrong investing in both index funds and mutual funds. If you want more of a big picture on investing, you can check out our guide on how to start investing as a beginner.