Index Funds vs. Mutual Funds: The Differences That Matter

The biggest difference between index funds and mutual funds is that index funds invest in a specific list of securities (such as stocks of S&P 500-listed companies only), while active mutual funds invest in a changing list of securities, chosen by an investment manager.

Over a long-enough period, investors might have a better shot at achieving higher returns with an index fund. Exploring these differences in-depth reveals why.

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Asset-weighted averages from Investment Company Institut

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Differences between mutual funds and index funds

Passive vs. active management

One difference between index and regular mutual funds is management. Regular mutual funds are actively managed, but there is no need for human oversight on buying and selling within an index fund, whose holdings automatically track an index such as the S&P 500. If a stock is in the index, it’ll be in the fund, too.

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Because no one is actively managing the portfolio — performance is simply based on price movements of the individual stocks in the index and not someone trading in and out of stocks — index investing is considered a passive investing strategy.

In an actively managed mutual fund, a fund manager or management team makes all the investment decisions. They are free to shop for investments for the fund across multiple indexes and within various investment types — as long as what they pick adheres to the fund’s stated charter. They choose which stocks and how many shares to purchase or punt from the portfolio.

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Investment goals

The sole objective of an index fund is to mirror the performance of the underlying index. But the objective of an actively managed mutual fund is to outperform the index — to earn higher returns by having experts pick investments they think will beat the market.

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History has shown that it’s extremely difficult to beat passive market returns (a.k.a. indexes) year in and year out. According to the S&P Indices versus Active (SPIVA) scorecard, only 12.02% of funds outperformed the S&P 500 in the last 15 years.

That being said, there are some fund managers that do beat the market, when the conditions are right. The scorecard says in the past year, 40.32% of funds have outperformed the market.

If you choose active management, particularly when the overall market is down, then you might have the opportunity to make higher returns, at least in the short term.

Instead of tracking an index, a fund manager could seek to diversity your portfolio a bit more, by buying value stocks, or asset weighting toward other companies.

But in exchange for potential outperformance, with an actively managed fund, you’ll pay a higher price for the manager’s expertise, which leads us to the next — and perhaps most critical — difference between index funds and actively managed mutual funds: Cost.

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Costs

As you can imagine, it costs more to have people running the show. There are investment manager salaries, bonuses, employee benefits, office space and the cost of marketing materials to attract more investors to the mutual fund.

Who pays those costs? You, the shareholder. They’re bundled into a fee that’s called the mutual fund expense ratio.

And herein lies one of the investing world’s biggest Catch-22s: Investors pay more to own shares of actively managed mutual funds, hoping they perform better than index funds. But the higher fees investors pay cut directly into the returns they receive from the fund, leading many actively managed mutual funds to underperform.

» How do fees impact returns?

Index funds cost money to run, too — but a lot less when you take those full-time Wall Street salaries out of the equation. That’s why index funds — and their bite-sized counterparts, exchange-traded funds (ETFs) — have become known and celebrated for their low investment costs compared with actively managed funds.

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But the sting of fees doesn’t end with the expense ratio. Because it's deducted directly from an investor’s annual returns, that leaves less money in the account to compound and grow over time. It’s a fee double-whammy and the price can run high.

Index funds also tend be more tax efficient, but there are some mutual fund managers that add tax management into the equation, and that can sometimes even things out a bit.

These mutual fund managers can offset gains against losses, and hold stocks for at least a year, resulting in long-term capital gains taxes, which are generally less expensive than short-term capital gains taxes.

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