Mutual Fund vs. Index Fund: What's the Difference?

Short answer: In the mutual fund vs. index fund question, the two aren't really opposites. An index fund is a type of mutual fund or exchange-traded fund (ETF) that tries to match the return of a market index, such as the S&P 500. The real difference is between index funds, which follow an index, and actively managed funds, where a manager picks investments to try to reach a goal. Index funds usually trade less, charge lower fees and have more favorable tax treatment, according to the SEC's Investor.gov.

What Is a Mutual Fund?

A mutual fund pools money from many investors and uses it to buy stocks, bonds, money market instruments or other assets. A professional investment adviser manages the holdings, and each share you own represents part ownership of the fund's portfolio.

A few features set mutual funds apart:

• How you buy and sell. You buy shares from the fund itself, or through a broker or investment adviser who buys them from the fund, not from other investors on a stock exchange. The price is the next calculated net asset value (NAV) plus any purchase fees.
• Selling. You can sell (redeem) shares back to the fund on any business day for the next calculated NAV, minus any redemption fees.
• Diversification. Spreading money across many companies and industries helps lower your risk if one company fails.
• Low minimums. Investor.gov lists relatively low minimum investments as one of the advantages of mutual funds.

Mutual funds come in several types, including stock funds, bond funds, target date funds and money market funds. If you're comparing places to keep cash, our guide to money market accounts vs. savings accounts explains how a bank money market account differs from a money market fund.

What Is an Index Fund?

Investor.gov describes an index fund as a type of mutual fund or ETF that tries to match the returns of a market index. You can't invest directly in an index, so an index fund is an indirect way to invest in one.

Some index funds hold every security in the index they follow. Others hold only a sample. Most indexes weight companies by market capitalization, so larger companies count for more, though some indexes, such as the Dow Jones Industrial Average, are weighted by share price instead.

Index funds generally take a passive approach. They trade less often and aim for long-term returns. Investor.gov describes this as a passive investing strategy.

Mutual Fund vs. Index Fund: How Do They Compare?

Because an index fund can itself be a mutual fund, the useful comparison is between index funds and actively managed mutual funds. Here's how the two styles line up, based on Investor.gov:

	Index (passive) fund	Actively managed fund
Goal	Match an index's return before fees	Reach a stated objective, which can include beating a benchmark
Who decides what to buy	The index sets the holdings	A manager buys and sells investments
Trading	Less frequent	More frequent
Fees	Usually lower, but not always	Usually higher than index funds; check the fund's expense ratio
Taxes	Usually more favorable, because the fund realizes fewer capital gains	Usually less favorable than index funds
Main risk beyond the market	Tracking error and less flexibility when prices fall	Results depend heavily on the manager's skill

Neither style is guaranteed. Mutual funds aren't guaranteed or insured by the FDIC or any other government agency, and you can lose some or all of the money you invest.

Why Do Index Funds Usually Cost Less?

Index funds don't need research analysts to choose securities, which can lower their costs. Investor.gov also notes that passive management typically means less trading, fewer transaction costs and lower fees than actively managed funds.

There's an important catch: Investor.gov warns that not all index funds are cheaper than actively managed funds. Always look at the actual fees before you invest.

How Much Do Fees Matter?

Fees and expenses reduce your returns, and a fund with higher costs must perform better than a lower-cost fund to give you the same result. Investor.gov uses a simple illustration: a $100,000 investment that grows 4% a year for 20 years. This is an example, not a forecast. At the end of 20 years, the portfolio would be worth approximately:

1. $208,000 with an annual fee of 0.25%
2. $198,000 with an annual fee of 0.50%
3. $179,000 with an annual fee of 1.00%

The fees you're likely to see on a mutual fund or ETF include:

• Expense ratio. The fund's total annual operating expenses, expressed as a percentage of its average net assets. Funds deduct these from the fund's assets, so you pay them indirectly.
• Sales loads. A front-end load is paid out of the money you invest. A back-end or deferred load is paid out of the money you receive when you sell. A no-load fund doesn't charge a sales load, but, as Investor.gov points out, no-load doesn't mean no fees.
• 12b-1 fees. Distribution fees, and sometimes shareholder service fees, that typically apply to mutual funds but not to ETFs.
• Brokerage commissions. You may pay these when you buy and sell ETF shares, in addition to the fund's own fees.

Mutual funds and ETFs must include a standardized fee table in their prospectuses. You can also compare the fees and expenses of different funds with FINRA's Fund Analyzer.

If you work with an adviser, their fee comes on top of the funds' own costs. Our guide to how much a financial adviser costs explains the common fee types, and the adviser fee calculator shows how a yearly percentage fee adds up.

What Are the Risks of Index Funds?

Index funds carry real risks. Investor.gov lists several:

• The index's own risks. An index fund carries the same general risks as the securities in its index.
• Less flexibility. An index fund may have less room than a non-index fund to respond to falling prices in the securities it holds.
• Tracking error. The fund may not match its index exactly, especially if it holds only a sample of the index's securities.
• Underperformance. Fees, trading costs and tracking error can cause an index fund to lag the index it follows.

An actively managed fund's performance depends heavily on the manager's skill, according to Investor.gov.

Index Mutual Fund vs. Index ETF: What's the Difference?

Index funds come in two structures, and the difference is mostly about how you trade them:

• Index mutual funds are bought from and sold back to the fund at the next calculated NAV.
• Index ETFs trade throughout the day on national stock exchanges at market prices. You may pay brokerage commissions, and the bid-ask spread, the difference between the bid and ask prices, is a hidden cost that reduces potential returns.

ETFs can be tax efficient because many of them buy and sell portfolio securities through in-kind exchanges rather than for cash. Investor.gov says this usually means fewer capital gain distributions than mutual funds, so ETF shareholders may pay less in taxes on a similar investment.

How Should You Choose Between Them?

There's no single right answer, and we don't recommend specific funds. Before you invest, Investor.gov suggests reading the fund's prospectus and most recent shareholder report and asking about fees, specific risks, how the index is built and whether the strategy fits your goals:

1. What does the fund cost? Find the expense ratio, any sales loads and any 12b-1 fees in the prospectus fee table.
2. How is the index built? For an index fund, find out which index it tracks and how that index is constructed.
3. What are the specific risks? Read the risk section, not just past performance. Past performance doesn't predict future returns.
4. Does the strategy fit your goals? Decide whether the fund's approach matches what you're investing for.

If you invest through a workplace retirement plan, our guides to how much to contribute to your 401(k) and 401(k) vs. 403(b) plans cover those accounts, and the retirement savings calculator can show how steady contributions could add up. If you'd like professional help, check the adviser's background for free before you hire them.

The Bottom Line

An index fund is a kind of mutual fund or ETF, not an alternative to one. The meaningful choice is between index funds, which follow a market index and usually cost less, and actively managed funds, which rely on a manager's decisions. Whichever you consider, compare the fees, read the prospectus and remember that mutual funds aren't insured by the FDIC or any other government agency.

FinancialAdviser.com doesn't recommend specific securities, and nothing here is investment advice. Investing involves risk, including the possible loss of principal.

Frequently asked questions

Is an index fund a mutual fund?

It can be. Investor.gov describes an index fund as a type of mutual fund or exchange-traded fund (ETF) that tries to match the returns of a market index. So an index fund can be a mutual fund, but not every mutual fund is an index fund.

Are index funds cheaper than mutual funds?

Often, but not always. Index funds don't need research analysts to pick securities, which can lower costs, and Investor.gov says they usually charge lower fees. It also warns that not all index funds are cheaper than actively managed funds, so check each fund's actual expenses.

Can an index fund lose money?

Yes. An index fund carries the same general risks as the securities in the index it tracks. Mutual funds aren't guaranteed or insured by the FDIC or any other government agency, and you can lose some or all of the money you invest.

What is the difference between an index fund and an ETF?

They overlap. An index fund can be structured as a mutual fund or an ETF. Mutual fund shares are bought from and sold back to the fund at the next calculated net asset value, while ETF shares trade throughout the day on stock exchanges at market prices.

Why do index funds have better tax treatment?

Index funds trade less often than actively managed funds. Investor.gov says their passive management typically means lower realized capital gains and more favorable income tax consequences.

Sources

1. Investor.gov (SEC): Index Funds
2. Investor.gov (SEC): Mutual Funds
3. Investor.gov (SEC): Mutual Fund and ETF Fees and Expenses
4. Investor.gov (SEC): Exchange-Traded Funds (ETFs)
5. Investor.gov (SEC): How Fees and Expenses Affect Your Investment Portfolio

This guide is general information, not personal advice. Your situation may differ, so consider talking with a qualified professional, such as a fiduciary financial adviser, CPA or licensed agent, before making a decision.