Buying shares of a fund rather than individual stocks makes it easier to invest. Funds offer instant portfolio diversification with very little work. You don’t have to stay informed on dozens of stocks when a fund does it all for you.
“Both index funds and mutual funds gather investments from a collection of individuals, creating diversified portfolios that span across several securities,” says Scott McBrien, founder and chief investment officer at The Laser, an investing system and app. “This diversification strategy effectively spreads the investment risk across multiple assets.”
The funds offer many similar benefits, but they also have key differences. Investors should know these differences before allocating their money to either type of fund:
Index funds are passive funds that mirror the returns of popular indexes like the S&P 500 and the Nasdaq 100. Index funds are less risky since they follow the market instead of trying to beat the market. As McBrien explains, that comes with a set of advantages and disadvantages.
“While striving to match the market, index funds seldom outperform it due to their goal of replication rather than outpacing it. Consequently, when the market experiences a downturn, index funds follow suit, reflecting the index’s performance. While the passive management keeps costs down, it also eliminates human decision-making, missing opportunities to capitalize on market trends or more profitable investments.”
Index funds stay the course and can hold onto laggards that an actively managed mutual fund might not. If a company is about to go bankrupt, index fund managers wait for the index to remove the company from its list before following suit.
Mutual funds give investors the opportunity to beat the market. These funds do not use indexes as their benchmarks and have more flexibility in which assets they can accumulate. A mutual fund manager conducts research and looks for market opportunities.
This approach creates more opportunities for investors but also increases risk. Mutual fund investors have to give more thought to who is managing the fund than index fund investors.
“Mutual funds’ performance varies widely based on the decisions made by the fund manager. Some mutual funds may outperform the market, while others may underperform,” McBrien says. “Their success depends on the fund managers’ skills and decisions. Changes in management or strategy can impact fund performance.”
While an active manager can outperform index fund returns, it’s not a guarantee. However, you are likely to encounter higher expense ratios and taxes if you use a mutual fund. Brian Spinelli, co-chief investment officer at Halbert Hargrove, explains why that’s the case: “If a mutual fund realizes gains on underlying investments, those gains get pushed to shareholders and become taxable events.”
Beating the market isn’t just a matter of outperforming an index. The mutual fund’s performance must exceed the sum of the market’s return, taxes and operating costs expressed as the expense ratio. However, some mutual funds are tax-efficient and minimize the capital gains they distribute to shareholders.
Mutual funds are optimal for investors who want the opportunity to outperform the market. These funds can also have goals that go beyond mirroring a popular stock market index. For instance, some mutual funds aim to hedge against inflation and economic uncertainties.
Investors considering mutual funds should go into it knowing that these funds are more expensive than index funds. Investors who don’t mind active management and the extra expenses may prefer these types of funds.
Mutual fund investors may be skeptical toward index funds since the latter funds hold onto underperforming stocks. For example, the top positions in the Nasdaq 100 and the S&P 500 are the “Magnificent Seven” companies. These companies are Amazon.com Inc. (ticker: AMZN), Apple Inc. (AAPL), Alphabet Inc. (GOOG, GOOGL), Meta Platforms Inc. (META), Microsoft Corp. (MSFT), Nvidia Corp. (NVDA) and Tesla Inc. (TSLA). Each of those stocks has comfortably outperformed the S&P 500 year to date and over the past five years. Amazon is the only stock on this list that has underperformed the Nasdaq 100 over the past five years.
Investors who gravitate toward mutual funds see this as an opportunity. Instead of wasting their time with many companies listed on the S&P 500, they only want exposure to the best of the best.
The Roundhill Magnificent Seven ETF (MAGS) has put this concept to the test and almost evenly spreads its assets across these seven stocks. This passively managed fund has outperformed the S&P 500 and Nasdaq 100 by comfortable margins since its inception on April 11, 2023. Although this fund is an exchange-traded fund, or ETF, it has the same appeal as a regular mutual fund because it aims to beat the market instead of following the market.
Mutual funds also cater to people who do not want to spend as much time in their portfolios. Mutual funds do not go through price fluctuations during market hours unless they trade as ETFs. These funds only change prices once at the end of the market day. Other stocks and funds trade throughout the day and can experience sharp price fluctuations during volatile trading.
Index funds are less risky since they mirror popular indexes and often have a lower expense ratio, but they also have a lower ceiling on their potential returns. While they cannot easily outperform the market, index funds have several strengths that attract long-term investors.
“Index-tracking funds usually have lower fees and generally lower tax events, such as capital gains distributions that do happen with mutual fund structures,” Spinelli explains. Buying an index fund is also the safer route instead of hoping the portfolio manager of an active mutual fund makes the right decisions.
Most mutual funds underperform the S&P 500. S&P Global uses the SPIVA U.S. scorecard to display the percentage of U.S. equity funds that underperform the S&P 500 and other benchmarks. Over the past 10 years, more than 90% of mutual funds have underperformed the S&P. More than half of mutual funds underperformed the S&P in 2022.
Investors should also consider their time horizon and financial goals before investing in index funds or any asset. Index funds can be more appealing to investors who believe they can have a good retirement just by mirroring market returns. These people may be more risk-averse compared with investors who will take some chances to outperform popular indexes.
Not everyone wants to choose between index funds and mutual funds. Some investors buy multiple funds to get exposure to more assets. However, investors should assess their portfolios and decide how much capital to allocate to each fund.
Index funds are generally less risky because they mimic market returns. Risk-averse investors may want to put a higher percentage of their cash into these funds compared with mutual funds. Investors who are willing to take on more risk for a higher potential payoff may want to put more of their money into mutual funds over index funds.
Index funds and mutual funds both allow investors to diversify their portfolios without analyzing stocks or doing as much research. You can let the fund do all of the work while you earn a return on your investment. Knowing your long-term financial goals and how much risk tolerance you have can help you make better decisions for your portfolio.