Since their initial inception in 1971 by William Fouse and John McQuown at Wells Fargo, index funds have become widely popular investment vehicles. They allow individual investors to mimic the performance of a specified stock market index. Subsequently, all the investment research required for individual stock picking is no longer necessary, and neither is learning about portfolio management. And even without making these typically critical moves, a decent return on investment can still be achieved over long time horizons.

Active mutual funds take this one step further. They employ expert financial analysts to build and run an investment portfolio to outperform a benchmark index. These types of funds grew increasingly popular during the 1950s and offer many similar advantages to index funds.

But when comparing an index fund vs a mutual fund, which is the best investment option for investors?

What is an index fund?

An index fund is also sometimes called a tracker fund and pools together shareholder capital to invest in stocks that belong to a specified index, such as the FTSE 100 or S&P 500. As previously mentioned, the investment objective is to track and replicate the performance of a benchmark stock market index. And as this is a form of passive investing, the expense ratio on these tracker funds is typically very low.

An index tracker fund can come in two forms, one of which is actually a type of passive mutual fund. The other is an index exchange-traded fund (ETF) which has been gaining more popularity in recent years due to its typically lower expense ratio.

What is a mutual fund?

The core operations of a mutual fund are remarkably similar to an index fund. It pools investor capital and then uses the money to invest in a diverse range of financial securities.

The list of asset classes typically includes:

• Stocks
• Bonds
• Commodities
• Real Estate
• Derivatives

Based on the asset classes the fund manager decides to invest in as well as the strategy being deployed, mutual funds can be categorised into five different types.

• Stock Funds – Invests exclusively in equities to match or outperform a stock market index like the S&P 500. When the fund attempts to replicate the performance of an index, it is classified as an index mutual fund.
• Bond Funds – Invests exclusively in debt securities such as government bonds, corporate bonds, municipal bonds, convertible bonds, and mortgage-backed securities, among others.
• Balanced Funds – Invests using both stocks and bonds to execute a specific investment strategy.
• Money Market Funds – Invests exclusively in short-lived debt securities such as treasury bills, commercial papers, and certificates of deposits.
• Target Date Funds – Invests in a wide range of asset classes, adjusting the strategy to become more conservative as the investor ages.

Passive mutual funds seek to track the performance of a benchmark index or sector. However, they can also use an active investing strategy to try and outperform the chosen benchmark. Obviously, this requires a more hands-on approach. And subsequently, the management fees and, in turn, the expense ratio is typically higher for an active fund versus a passive fund.

A mutual fund’s share price is determined by the Net Asset Value (NAV) – the value of its investment portfolio. Trades to buy and sell shares in a mutual fund are settled at the end of each trading day which is also when the NAV updates as well.

Index fund vs mutual fund: The similarities

• Instant Diversification – Index funds and mutual funds invest in a diverse range of financial securities, such as stocks, to achieve their investment objective.
• Optionality – Both fund types can cater to a broad range of investor goals, risk tolerances, and time horizons.
• Trade Executions – Trades for both index funds and mutual funds are settled at the end of each trading day. This is because shares in mutual funds are not traded over a stock exchange. The exception is an index ETF. Trades to buy and sell index ETF shares can be instantly executed instantly while the markets are open.
• Investment Requirements – Index mutual funds and other types of mutual funds often require investors to invest a minimum amount of capital in becoming a shareholder. However, an index ETF does not have minimum investment requirements. Investors simply need to be able to afford at least one share at the current stock price. Having said that, some stock brokers offer fractional shares for index ETFs with high trading volume.
• Dividends – Shareholders of both index funds and mutual funds are entitled to any dividends or coupons paid by the securities within a fund’s portfolio. Depending on the dividend policy, these gains are either redistributed via a dividend or reinvested into the fund’s portfolio.

Index fund vs mutual fund: The differences

• Investing Strategies – Index funds exclusively focus on executing a passive investment strategy. Mutual funds can choose to implement a passive or active investing strategy.
• Fees – As index funds are passively managed, the expense ratio tends to be relatively low. The same applies to passively managed mutual funds. However, actively managed mutual funds often charge significantly higher fees that can harm investor returns.
• Asset Class Exposure – Index funds invest exclusively in the constituent stocks of a particular index. On the other hand, an active mutual fund can use other asset classes like bonds and real estate to try and achieve its investment objective.
• Performance – Index funds will always generate a return identical to the benchmark index it is tracking before management fees. Active mutual funds may deliver returns that exceed a benchmark index leading to market-beating returns. However, as with anything in the world of investing, there is never a guarantee of success.

The bottom line

Index funds and mutual funds both offer low-risk, diversified investment opportunities. One carries the potential of outperforming the stock market. The other mirrors the market performance. Yet both help investors bypass many of the more complex aspects of investing, such as time-consuming investment research, individual stock picking and portfolio management.

But which is the better investment? This ultimately depends on the investor’s investment goals, risk tolerance, and time horizon. Those looking to build wealth quickly and are willing to accept a higher risk level may favour an active mutual fund. Alternatively, index funds may be more appropriate for investors happy with matching the stock market’s performance.

In either case, investors need to be mindful of the fund’s management fees, as these can adversely impact investment returns. And if there is any uncertainty in making an investment decision, it’s often recommended to seek help from a qualified independent financial adviser.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.