Let’s start with the basics. Index funds and Mutual funds are ways for investors to diversify their portfolios by investing in dozens, hundreds or even thousands of stocks at one time. The main difference is that index funds track a specific group or “index” of stocks, for instance, you can buy SPY index fund that tracks the S&P 500 exactly, while mutual funds often have a professional money manager pick and choose which stocks the mutual fund will invest in. There are also passively managed mutual funds (such as Vanguard) which are actually more similar to an index fund than a traditional, actively-managed mutual fund. So, from this point forward, when referring to mutual funds, note that I am referencing actively-managed mutual funds. There are pros and cons to both of these and we will go into more detail below.
Index Funds
Pros to investing in an Index fund-
They charge very little fees, typically much less then mutual fund fees. This is a very cheap and easy way to diversify your portfolio.
If you don’t have a lot of time to constantly keep up with the stock market, and index fund is great because it requires almost no knowledge to make money with an index fund.
If you don’t need your money for a long time, also known as being a passive investor, that is, you plan on putting money into the index fund and keeping it there for a long time then an index fund is the way to go. By doing this, you are allowing your money to keep adding up.
Index funds are usually more liquid, meaning they are much easier to buy and sell.
The market is efficient, so annualized index fund returns, on average, tend to actually be a little higher than mutual funds.
By keeping your fees low, maintaining the average market return, and keeping your money in an index Fund you allow your money to start compounding. (One of the biggest threats to compound interest is high fees)
Cons to investing in index funds-
The results can be “underwhelming”, that is, you are just earning the rate of return for the market. Some people think they can “outsmart” the market and earn a higher return would probably prefer Mutual funds.
Because you’re investing in a specific “basket” of stocks, you get the returns of the good stocks but also the bad stocks.
If the market is losing money, it probably means that you’re also losing money.
Mutual Funds
Pros to investing in a Mutual fund-
You have a professional money manager(s) that manages the fund with their sole job being to make you as rich as possible.
Fund managers can react quickly to market changes, so they can buy or sell more shares of a certain stock, in an index fund you can’t.
You have the possibility to get higher returns than the market. There is sometimes more risk in a mutual fund but they payoff can be worth it if you can beat the market returns.
Mutual funds can also be a safer investment, this all depends on the type of mutual fund but some mutual funds will invest in bonds as well as fixed income stocks that pay a dividend. In funds like this, returns are usually lower, but risk is usually lower and returns are usually more predictable. This is a favorite among older or retired investors who don’t want as much risk but want to live off the steady income from the mutual fund.
Cons to investing in a Mutual fund-
Expenses- this is a huge con with mutual funds because they charge annual fees as a percentage of the total investment. Many mutual funds charge around a 2% annual fee but that fee can go as high as 8%. This essentially comes right out of your investment returns… and here’s the worst part- you get charged that fee whether you’re making money or not.
Mutual funds must buy stocks that are within certain guidelines that are specified in its prospectus. For example, a “small market capitalization fund” cannot buy a stock with a large market capitalization even if it represents a better buying opportunity. Meaning that when a mutual fund has excess cash, it may be forced to buy shares of a less desirable stock.
Tax Consequences- this is a harder concept to understand and this is one important way mutual funds differ from index funds. When a mutual fund sells a stock for a profit, they pass that tax bill onto you in the form of annual capital gains distribution. You can’t control when this happens, so you may have a higher tax burden. In some cases, you may be losing money in your mutual fund account but if they sell one of their stocks for a profit, you end up paying taxes on that one stock.
In conclusion, there is no one-size-fits-all answer to which one is better for you. What’s best for one person may not be what is best for you. If you are younger and just starting out with your investment account I would recommend index funds because while new mutual funds constantly come and go, index funds are tried and true. They have a long history of earning great returns and they have low fees. If you are younger, you can put your money in an index fund and not have to worry about it, you can sit back and watch your account grow from year to year. However, I know index funds aren’t for everyone and that is exactly why mutual funds were created, and there is just about every kind of mutual fund for every type of investment goal.