Mutual Funds vs. Index Funds: Pros & Cons

Image Credit: Kritsana Bunpok/iStock/GettyImages

Mutual funds or index funds are investment bundles that offer convenient, low-cost options and portfolio diversification without an individual investor having to select and manage individual stocks. Differences between mutual funds and index funds start with how they are managed, the fees you'll pay to purchase them and the returns you might expect.

Advertisement

Active Management vs. Passive Investing

Actively managed mutual funds have a professional fund manager creating the investment strategy, managing the trading activity and monitoring the fund. The fund manager will evaluate the fund's performance and buy and sell accordingly. This type of active investment usually comes with a load, or sales charge, that investors pay upfront to cover the management cost. The Financial Industry Regulatory Authority (FINRA) caps the load that can be put on a mutual fund at 8.5 percent.

Advertisement

Video of the Day

On the other hand, index funds are considered passive investing because the fund is not actively managed. An index fund's portfolio is based on established stock exchange indexes, such as the S&P 500 index, the Nasdaq Composite Index and the Dow Jones Industrial Average. The goal of an index fund is to meet the index's performance. Because the pre-packaged index doesn't require buying, selling and active monitoring, upfront fees for fund investors are typically less than those of mutual funds.

Advertisement

The active or passive management of index and mutual funds is a key difference between these two types of investments.

The active or passive management of index and mutual funds is a key difference between these two types of investments.

Advertisement

Expense Ratios

The management fees associated with the fund and overhead costs of the fund company are passed on to investors in the fund's expense ratio, which is typically seen as a percentage rather than a dollar amount. These fees vary between funds and can make a big difference in your investment returns because they are deducted regularly from the fund's total value, decreasing the total payout distributed among investors.

Advertisement

In 2021, according to Vanguard,.) the expense ratio across the fund industry was 0.49 percent or $9 for every $10,000 invested. Knowing that industry average will help you see if you are paying higher fees.

Mutual funds, with their active management, tend to have higher fees. Different types of mutual funds will have different fees. The Financial Industry Regulatory Authority (FINRA) has a mutual fund analyzer to help you compare the costs between funds.

Advertisement

The passive management of index investing makes for a lower cost-expense ratio.

Pros of Mutual Funds and Index Funds

Mutual Funds

Built-in diversification

Actively managed by a professional

Potentially higher returns

Long-term growth potential

Low to moderate risk

Liquidity

Index Funds

Built-in diversification

Passive investment

Low cost

Long-term growth potential

Relatively low volatility

Tax efficient

Both fund types offer convenient and low-maintenance portfolio management for the individual investor. Mutual and index funds may have less volatility than some investments due to diversification.

Advertisement

Mutual funds have greater liquidity. Your shares can be redeemed at any time. Index funds, on the other hand, tend to perform for the long term.

With the help of a financial advisor, a beginner investor can incorporate mutual funds and index funds into their investment strategy without having to research, track and invest in individual stocks and bonds.

Advertisement

Drawbacks of Both Types of Investments

Mutual Funds

Higher fees at buy-in

Fees at redemption

Tax implications

Less predictable returns

Index funds

Less flexibility

Lower average returns

Longer return cycle

Less liquidity

Some types of mutual funds and index funds can only be traded once daily after the markets close, limiting an investor's flexibility. Different funds carry different amounts of risk, react differently to market volatility and aim for varying levels of return. Depending on how often – and how high – they pay out, funds may be subject to regular income tax rates or higher capital gains taxes.

Advertisement

Not all drawbacks apply to every mutual fund or index fund.

Where ETFs Fit

ETFs, or exchange-traded funds, are not mutual funds but share many similarities. An ETF is an investment fund consisting of a combination of asset classes. They are purchased from a brokerage firm, actively managed and traded on the stock exchange.

Advertisement

The key differences between an ETF and a mutual fund are the lower fees and lower minimum initial investment of an ETF.

An index ETF is more similar to an index fund in that it tracks a benchmark index and tries to match its returns. The index ETF combines an index fund's diversification, simplicity and lower costs with greater trading flexibility. ETFs can be traded any time the stock market is open.

When considering whether to invest in passive or active funds, consult your financial advisor to learn what aligns best with your personal finance and investment goals. Among other investment decisions, which investment vehicle is right for you is a discussion best had between you and your financial advisor.

Advertisement

references