If you want to start investing, but don’t want to build your own portfolio with individual stocks, you could consider mutual funds and exchange-traded funds (ETFs). Both pool many investors’ money to create a collection of assets. An index fund, which could be either an ETF or mutual fund, is a popular investment because it aims to track the returns of a market benchmark, like the S&P 500®,1 offering stock diversification in one security.
When investors seek to learn about mutual funds vs. index funds, they may be looking to compare a passive management strategy associated with index funds with actively managed mutual funds, which have more hands-on fund managers who routinely make changes to the fund’s composition. In this case, active mutual funds and index funds’ investment goals, returns, and fees can differ.
Key differences between actively managed mutual funds and index funds
Learning how these investments contrast can help you decide what’s right for you.
Vehicle
An index fund could be a mutual fund or exchange-traded fund. Index fund refers to the investment objective of a fund, whereas mutual fund or ETF describes the vehicle, which has an impact on when you can trade shares and how it’s taxed. There are many more index ETFs than index mutual funds.
Management
An index fund’s primary investment strategy is to mimic the return of a market index, like the S&P 500® or the Nasdaq®.2 That’s why index funds tend to be passively managed—no need for a fund manager to buy and sell assets daily to seek to outperform the benchmark.
Actively managed mutual funds tend to aim to outperform an index or other benchmark, and their managers would likely spend considerable time researching the investments and changing the portfolio based on market conditions.
Returns
A passively managed index fund aims to earn the return of its underlying benchmark. There’s not much variety by fund or manager, though they could have different fees or tracking errors (the discrepancy between how the fund tracking the index performed vs. how the index itself performed). With actively managed mutual funds, the returns vary much more by fund. Some managers successfully beat their benchmarks. Other actively managed funds do not, and as with any investment, you may lose money.
Fees
Since active mutual funds require more investment research as well as buying and selling, these funds tend to charge higher fees than passively managed index funds (mutual fund or ETF). According to the Investment Company Institute, the average index mutual fund charged an expense ratio of 0.05% in 2023, whereas the average actively managed equity mutual fund charged 0.65% in 2023.3
To put those numbers in context, if you invest $5,000, you’d owe $2.50 per year in fees on average for investing in an index fund and $32.50 on average for investing in an actively managed mutual fund. So the challenge for an actively managed mutual fund is to not only earn more than their benchmark, but also earn more than the amount investors are paying in annual fees.
Research time
If you go with an actively managed mutual fund, you could spend more time researching which fund to invest in. There can be a wide range of different strategies, fees, and long-term performance from fund to fund. You also may want to pay closer attention to the investments in the fund, as the manager could change their approach over time. It’s possible a particular actively managed mutual fund may no longer be appropriate for your goals at some point.
Index funds are generally more straightforward. The assets chosen for the fund are not likely to be sold off, provided the composition of the index itself doesn’t change. Still, it’s a good idea to compare fees and check how closely the index fund’s performance has matched that of the index it tracks.
Tax efficiency
When funds sell investments for a gain, those profits are taxed, and that expense is passed on to fund investors. So you could owe taxes even if you haven’t sold any shares in your portfolio. Since actively managed mutual funds trade more often than passively managed index funds, active mutual funds typically incur more taxes.
Major similarities between mutual funds and index funds
Despite their differences, index funds and actively managed mutual funds have some common traits.
Large, ready-made portfolios
Index funds and actively managed mutual funds both allow you, with a single purchase, to immediately have exposure to many investments. You don’t have to go through the work of buying and managing dozens, if not hundreds, of investments individually.
Professional management
Both index funds and active mutual funds are managed by professional investors—typically through an asset manager—even if the fund doesn’t require a lot of day-to-day activity.
Variety of investment strategies
Whether it’s focusing on a specific industry, supporting only environmentally friendly companies, or prioritizing growth over income, there are index funds and active mutual funds for many different goals. Both allow for diversification of your investments, potentially reducing the risk of investing too heavily in any one asset.
Management fees
Index funds and active mutual funds both charge an annual expense ratio to compensate the manager overseeing the fund. The fee for investing in a passive index fund tends to be substantially lower than active funds. Still, in both cases, you wouldn’t owe this fee if you built the same investment portfolio yourself, though you could encounter trading fees on your own.
When should you pick an index fund vs. active mutual fund?
Whether an active mutual fund vs. an index fund makes sense depends on your personal investing goals, but these general guidelines could help you decide.
When investing in an index fund could make sense
- You want to keep investing simple. Index funds are generally easy to understand—you want to invest and ideally achieve the same performance as this preset group of investments—and take little research to compare. They also require minimal work to manage after purchasing fund shares. You don’t have to monitor the fund as closely to see whether the manager is making big changes or if the strategy no longer works for you.
- You don’t mind earning only an “average” return. When you invest in an index fund, you’re not likely to get huge returns that beat benchmarks. Still, over time, large indexes have averaged significant returns that have helped investors grow their money. That could help you reach your long-term goals, though past performance doesn’t guarantee future results.
When investing in an active mutual fund could make sense
- You’re interested in smaller, niche markets. Some of the top-performing mutual funds in the past decade were in niche areas like semiconductors or focused on smaller companies. Fund managers may struggle to find investment opportunities in large indexes like the S&P 500® because there’s so much competition and information is readily available about the largest companies. However, in niche markets like international stocks or small-cap pharma, there isn’t. As a result, it’s possible that a fund manager specializing in these areas could find good opportunities that could give you a potentially higher return.
- You’d like protection against market downturns. An active mutual fund can try to adjust its strategy to potentially protect against or reduce losses in an overall market downturn. Bond mutual funds also could reduce potential losses by steering clear of certain bonds at certain times.
Keep in mind this isn’t an all-or-nothing decision. You can split your portfolio between index funds and active mutual funds. For example, you might invest for the long term in index funds in your retirement account while using your brokerage account to buy mutual funds to potentially earn higher, short-term returns.
How to buy active mutual funds and index funds in a brokerage account
The process for buying active mutual funds and index funds is very similar.
- If you don’t have an investment account with a brokerage firm, such as Fidelity, spend some time researching and evaluating your different options. Consider the quality of a broker’s investment platform, research tools, and breadth of active mutual funds and index funds. Some companies may focus on different areas or specialize in active mutual funds vs. index funds.
- Open a brokerage account.
- Closely compare the different funds’ fees, investment strategies, and investment minimums.
- Decide what mix of index and/or active mutual funds makes the most sense for your portfolio.
- If you don’t already have money in your investment account, add enough to cover the funds you want to buy.
- Follow the instructions at the bottom of the following article to invest in index funds, mutual funds, and ETFs.
You may be able to invest in index funds and mutual funds using your personal or workplace retirement accounts too.