Index funds vs. mutual funds: What's the difference?

• Index funds and mutual funds let you invest in a variety of stocks, bonds and assets without having to cherry-pick your investments.
• While mutual funds are actively managed by an investment professional, index funds are more passive, making them good for hands-off investors wanting steady returns.
• Mutual funds come with much higher fees than index funds, which can cut into your potential gains.

For many beginning investors, the idea of hand-picking stocks can probably seem quite daunting. Fortunately, with tools like index funds and mutual funds, that type of legwork isn't actually necessary to start your investing journey.

Here's what you need to know about these investment vehicles - and when you might want to invest in them.

Index fund vs. mutual fund: at a glance

Both index funds and mutual funds allow you to invest in a variety of assets without having to cherry-pick those investments one by one. The major differences are how those funds are managed and their earning potential.

Here are the basics of both types of funds:

• An index fund is a pool of investments that aims to mimic the performance of a certain market index - often the S&P 500, the Dow Jones Industrial Average or the Nasdaq Composite (though there are many more.) Investors buy shares in the fund and see gains when stocks within the fund grow in value.
• A mutual fund is a company or fund that invests in a variety of assets, including stocks and bonds. Investors can then purchase shares of the fund, thereby purchasing a stake in all companies within that portfolio. Unlike index funds, mutual funds are actively managed, meaning a professional monitors the portfolio's performance and regularly makes buys and trades within it.

According to Matthew Willett, an investment advisor at WealthPlan Advisors in Scottsdale, Ariz., both funds offer baskets of securities, which investors can then buy shares of.

"Instead of buying shares of many individual companies, investors can purchase shares of a fund made up of hundreds or thousands of companies," Willett says. "As the companies within the fund either increase in share price or decrease, the value of investors' shares in the fund will change in conjunction."

Index fund

An index is a type of mutual fund or ETF that aims to match the returns of a certain index. The S&P 500 is one of the most commonly used indices, but there are many others, too, including the Wilshire 5000 Total Market Index, the Russell 2000 Index, and the Dow Jones Industrial Average.

With an index fund, money is invested into securities within the aligned index - sometimes all of them, sometimes just a sampling. The ultimate goal is to mirror the performance of the overall index and deliver similar returns to the fund's investors.

Investors usually gain a small percentage annually. According to 2020 data, the S&P 500 returned 13.6% annually over the last 10 years. Historically, annual returns have averaged 9.2%.

Because index funds don't require regular trading or selling, they're considered passive investments, and they aren't actively managed by a professional. This means fees are smaller on these funds than on other investment vehicles - particularly when compared to actively managed mutual funds.

"An index fund would be best for someone who did not have a lot of money and was just starting to invest," says Josh Simpson, vice president of operations and investment advisor with Lake Advisory Group. "This would allow them to achieve diversification with their investment without having to spend hours learning how to invest."

Example of how an index fund works

The Vanguard 500 Index Fund is a good example - and is actually the first index fund to ever exist. The fund tracks the S&P 500 Index and contains shares of all 500 companies within it. It has delivered an average annual return of 7.84% since 2000, just under the Index's average in that timeframe.

Mutual funds

Mutual funds, like index funds, invest in a variety of stocks, bonds, and other assets, only they're not trying to track the market - they're trying to beat it. Mutual funds come in several types, including money market funds, bond funds, target date funds, and stock funds (index funds fall into this category.)

The majority of these funds (aside from index funds) are actively managed, which means an investment professional will sell and purchase shares within the portfolio regularly in an effort to maximize returns. While this does open the door for higher potential gains than index funds, it also means returns are unpredictable.

"The reason someone would choose an actively managed mutual fund is that if one can identify a fund manager that can consistently beat the market, one can accrue tremendous wealth," says Robert Johnson, chairman and CEO of Economic Index Associates and a professor of finance at Creighton University. "For instance, investors who invested in the Fidelity Magellan fund during the time period Peter Lynch managed it earned an average of 29.2% during his time running it - more than twice what the S&P 500 earned during that time."

Those kinds of gains aren't guaranteed, though. And in many cases, actively managed funds actually underperform the market. According to data from the S&P Dow Jones Indices, 82% of large-cap funds underperform the S&P 500 over a 10-year period.

Quick tip: Actively managed funds come with higher fees than passive ones (like index funds). According to the Investment Company Institute (ICI), the average fee for equity mutual funds is 1.16%. On index funds, it's just 0.58%.

Example of mutual funds

Say you plan on retiring in 2045. If you want to maximize your available cash by that time, you might consider a 2045 target date fund - an actively managed mutual fund with an established end date. To participate, you'd purchase shares of the fund - along with other investors looking to retire around the same time - and your fund manager would buy and sell assets to help you reach your goal by the target date.

Quick tip: If you opt for a mutual fund, make sure you choose your fund carefully. Your fund manager will play a critical role in reaching your financial goals.

The financial takeaway

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.

If you're not sure which is best for your goals, speak to a financial planner. In many cases, both investment vehicles may be the right choice for your long-term wealth.