If you’re looking to start investing, you might be wondering whether you should put your money into index funds or mutual funds. Both offer access to the stock market, and other areas of the world’s financial markets, but they approach things in different ways.
To help you work out which type of fund aligns best with your financial goals, we have put together this guide. Here’s a look at some of the key differences between index funds and mutual funds.
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What are mutual funds?
To understand how these products differ, it’s best to start with a look at what mutual funds are.
Sometimes called investment funds, mutual funds are investment products that provide diversified exposure to different asset classes.
With these products, investors’ money is pooled together to form a larger amount of capital for investment.
This capital is then managed by a professional fund manager or fund management firm, who will select investments for the fund on behalf of all the investors.
What are index funds?
Today, there are many different types of mutual funds available to investors.
And one type is index funds.
With this type of mutual fund, there is no portfolio manager actively selecting the investments for the fund. Instead, the fund will simply aim to track an index such as the S&P 500 or the Nasdaq 100.
Given their focus on tracking indexes, index funds are often called ‘passive’ funds or ‘tracker’ funds.
How are index funds similar to mutual funds?
Index funds are similar to mutual funds in several ways.
For a start, they are both pooled investment vehicles, meaning that they pool money from many different investors to buy a basket of securities.
Secondly, they both offer diversified exposure to different asset classes.
Additionally, index funds and mutual funds are both subject to regulation designed to protect investors.
How are index funds different from mutual funds?
However, there are key differences between the two types of funds.
The main differences are in relation to investment strategy and costs.
In terms of investment strategy, index funds will always invest passively. However, mutual funds may be actively managed or passively managed.
As for costs, index funds nearly always have very low fees. By contrast, mutual funds can have higher fees, depending on the strategy of the fund.
Pros & cons of index funds
Pros include:
- Low costs – index funds usually have very low fees.
- Diversification – with index funds you can get exposure to hundreds or thousands of stocks through one product.
- Simplicity – index funds are very simple and easy to understand.
Cons include:
- Market returns – index funds will never beat the market.
- Limited downside protection – regular index funds don’t offer strategies to hedge against market weakness.
- Less control – with index funds, you don’t have a say in which companies your money is invested in.
Pros & cons of mutual funds
Pros include:
- Diversification – through one product you can get exposure to many different stocks.
- Professional expertise – with mutual funds, you benefit from the expertise of a professional fund manager.
- Low hassle – with these investment products, you don’t have to worry about picking individual stocks yourself.
Cons include:
- Fees – over time mutual fund fees can eat into your returns.
- Lack of transparency – mutual funds often do not disclose their full holdings.
- Less control – with mutual funds, you don’t have a say in which companies your money is invested in.
What’s best – index funds or mutual funds?
In terms of what’s best out of index funds or mutual funds, this will depend on your investment goals and risk tolerance. Ultimately, there is no one-size-fits-all answer here.
Index funds might be the best choice for you if:
- Low costs are a priority.
- You’re comfortable with returns in line with the market’s performance.
- You want to track a particular index.
Whereas mutual funds might be the best choice for you if:
- You’re seeking the potential for higher returns through active management.
- You want to invest with a particular style or target certain areas of the market.
- You have a higher risk tolerance and are comfortable with returns that differ from market returns.
It’s worth pointing out that index funds and mutual funds are not mutually exclusive investments. If you want to, you can combine both in an investment portfolio.
Need help investing?
If you’re looking for information on how to invest in index funds or mutual funds, you can find some great tips in our guide on how to invest in mutual funds. This walks you through the steps involved in investing in mutual funds for the first time.
FAQs
Is the S&P 500 a mutual fund or index fund? The S&P 500 is neither a mutual fund nor an index fund. Instead, it is a stock market index. However, there are index funds that track the performance of the S&P 500.
What is the average return on index funds? The average return on index funds varies depending on the specific indexes the funds track. However, over the long term, index funds tracking the S&P 500 have historically delivered a return of about 10% per year.
What is the average return on mutual funds? The average return on mutual funds varies depending on the type of fund. However, over the long term, most stock market-based mutual funds have returned around 7-10% per year.
Which are best for beginner investors? If you’re just starting out in the investment world, index funds are often a good choice. That’s because they offer diversified exposure to the markets at a very low cost.
Based in London, Edward is a distinguished investment writer with an extensive client portfolio comprising a diverse array of prominent financial services firms across the globe. With over 15 years of hands-on experience in private wealth management and institutional asset management, both in the UK and Australia, he possesses a profound understanding of the finance industry.
Before establishing himself as a writer, Edward earned a Commerce degree from the prestigious University of Melbourne. Complementing his academic background, he holds the esteemed Investment Management Certificate (IMC) and is a proud holder of the Chartered Financial Analyst (CFA) qualification.
Widely recognized as a sought-after investment expert, Edward’s insightful perspectives and analyses have been featured on sites such as BlackRock, Credit Suisse, WisdomTree, Motley Fool, eToro, and CMC Markets, among others.
You can contact Ed at edward@goodmoneyguide.com
