Mutual Funds vs. Index Funds

by Brian Nelson ; Updated July 27, 2017

Mutual funds provide a great many advantages to investors. Funds are typically diversified across multiple holdings. Additionally, they are often professionally managed (whether they are active or passive), and can be easier to purchase than a similar basket of securities purchased individually. A wide variety of mutual funds, including index funds, is available to most investors.

Types

Mutual funds are an investment product in which the money of many investors is pooled. This pool of money is used to purchase securities, and the investors participate in the fluctuations of price and income according to their percentage ownership in the pool. Index funds are one of many types of mutual funds. The primary difference between index funds and other mutual funds is that index funds are invested according to a published index, instead of according to the mutual fund manager's strategy.

Misconceptions

It is impossible to actually invest in an index. Index funds do not invest directly in the index which they track, nor do they necessarily invest in exact percentages matching the index. Instead, index funds invest in the securities of an index in a way that approximates the same return as the index.

Warning

Index funds are often touted for their low expenses. While this is true in the case of some index funds, it is not a requirement. Investors should carefully research the expenses of index funds.

Considerations

Index funds can provide either a core investment for a portfolio or exposure to additional investment areas. Sector-based index funds can provide a solid way to get exposure to a specific market segment, while broad-based index funds can provide exposure to virtually an entire market.

Benefits

Index funds are generally cheaper, because they need not be managed (since they merely try to mimic an existing investment concept). This may provide higher long-term returns, assuming that the index fund performs as well as or better than the alternate non-index fund.

Significance

While mutual funds have a longer history, index funds have become a powerful force in investing. Investors attracted to the lower expenses of index funds have poured money into them. This has allowed Vanguard, one of the largest sellers of index funds, to become one of the largest mutual-fund companies in the world.