Index Funds vs. Mutual Funds

Mutual funds and index funds are investment vehicles to help you build your nest egg. But what’s the difference between them, and how do they work?

First off, index funds are actually a type of mutual fund—although when most people refer to “mutual funds,” they mean actively managed funds, whereas index funds are passively managed. That’s one key distinction between the two strategies, and we’ll get into more detail so that it’s crystal-clear.

In addition to management approach, the fees you’re charged and each fund’s performance also differ. We break it all down so you can get a better grasp on the way they operate and determine which is the right fit for you. (Spoiler alert: All signs point to index funds as the clear winner.)

The Management Strategy

A mutual fund is an actively managed investment account. It’s overseen by a money manager who selects which securities (stocks, bonds, etc.) to include in your portfolio, monitors their performance, and decides when to trade them.

Mutual funds take a hands-on approach with the goal of beating the market. They do so by hiring analysts who evaluate market conditions, identify stocks they believe are over- or under-valued, and forecast future prices. The analysts use this information to strategically time when to buy and sell certain shares.

Index funds, on the other hand, are passively managed. Rather than a team of pros supervising your assets and striving to outdo the market, index funds simply mirror the market itself, by generating earnings that equal the returns of a certain stock market index.

A stock market index is a collection of stocks that serve as a barometer for the health of the market—and U.S. economy—at large. For instance: The S&P 500, which is widely considered the most accurate representation of market conditions, includes the 500 largest publicly traded companies in the U.S., each weighted according to their importance.

An index fund tracks the trajectory of a certain stock market index (usually the S&P 500) by purchasing shares of all the stocks in that index in amounts proportional to their weight in the index. Since the stock market historically keeps rising, the theory is that your portfolio (or grouping of financial assets) will organically grow right along with it.

The Fee Structure

Mutual Funds

Since mutual funds rely on the financial expertise of stock-pickers, they draw a premium price. After all, the person-power put into supervising your accounts demands a significant overhead, from staff salaries to office space. To cover those costs, they charge a 0.67 percent fee on average, according to a Morningstar study.

That means if your account has total assets of $10,000, your money manager takes $67 off the top. It might not sound like a whole lot, but over time it adds up: not only because you’ve got $67 less in your pocket, but it’s also $67 less that you have to invest—and earn interest on—year after year. What’s more, you typically also have to pay a commission each time a stock is bought or sold.

Index Funds

On the other hand, because index funds are automated to follow the ups and downs of a stock-market index, minimal work is required and therefore they don’t cost nearly as much to maintain. Morningstar’s study found that annual fees clocked in at just 0.15 percent. Net-net: Mutual fund investors paid about 4.5 times as much as index fund investors on each dollar last year.

The Returns

Investors who opt for mutual funds may be betting that savvy stock pickers can outperform the market and generate premium outcomes. Because they’re not tied to a certain index, money managers are free to pursue “hidden gems”—companies that they believe will be the next big thing. The hope is that you’ll purchase relatively low-priced shares before the hot new biz takes off, the stock price will later soar, and boom: You’ll make bank.

The reality, however, is much less rosy. Over a 10-to-15-year time span, only about 20 percent of actively managed accounts surpass the market. Once you tack on all the extra fees and trading commissions, you’ll rarely come out ahead. For example, the average annual returns for the S&P 500 over the last 10 years were 13.49 percent. If you add the 0.67 percent fees and estimated 1.44 percent in annual transaction costs, money managers need to rake in 15.6 percent just to match the market.

An analysis from NerdWallet looked at the following scenario: Let’s say a 25-year-old has $25,000 in a retirement account and adds $10,000 to it each year, with a seven percent annual average return. If he or she were paying a one percent fee on those assets, it would equal more than $590,000 in lost earnings by the time that person reached retirement age 40 years later.

While mutual fund managers are busy buying and selling stocks, index funds skip the flurry of transactions in favor of a buy-and-hold approach, a passive investing strategy where an investor buys stocks (or other types of securities) and holds onto them for an extended period of time.

Not only does this translate into lower fees, since you’re charged every time you make a trade, but research suggests that buy-and-hold yields higher earnings. In fact, a Vanguard analysis found that buy-and-hold consistently outperformed the performance-chasing method by a margin of 1.5 to four percent over a nine-year period.

Despite their less than stellar returns, mutual funds still prevail, comprising 61 percent of the overall market share for U.S. funds, compared to 39 percent for index funds, as reported by Morningstar. But it’s no surprise that index funds are gaining steam. In fact, they’re predicted to overtake mutual funds by 2021, Moody’s Investor Services revealed in a recent report.

Whatever you decide, investing is a recipe for financial security. Do your future self a favor and pay yourself first.