Wall Street has an impressive track record for those willing to invest over long periods of time. The average stock market return for 10 years is 9.2%, according to Goldman Sachs data for the past 140 years. Of course, that is if investors choose to invest in funds that mimic the broader market’s returns. Individual stock investors may increase their returns, but not without inviting more risk. Therefore, investors who want to minimize risk while realizing returns close to the 10-year average should consider investing in funds, which begs the question: Which funds are best suited for today’s investors?

There are several types of funds investors may choose to invest in, but each offers something different. Some funds are better for investors with longer investing timelines, while others are better suited for those on the brink of retirement. The following is designed to help investors end the mutual fund vs. index fund debate and perhaps even help them choose where their money will realize the best returns for their particular situation.

What Is A Mutual Fund?

A mutual fund is an investment vehicle that allows investors to pool their money together to invest in securities. However, it is worth noting that investing in a mutual fund is more of an investment in a particular money manager. If for nothing else, individual investors are not responsible for picking their securities the mutual fund will invest in. Instead, investors choose which mutual fund to invest in based on predetermined securities and benchmarks. Once investors determine which mutual fund will help them meet their needs, they put their money in the hands of the mutual fund’s money managers. Once the fund managers receive the investors’ money, they will split up the collectively pooled capital and divide it amongst a predetermined “basket” of stocks, bonds, money market instruments, and similar assets.

What Is An Index Fund?

An index fund is a specific type of mutual fund or exchange-traded fund (ETF). Like mutual funds, index funds will pool together capital from individual investors for money managers to invest accordingly. However, instead of investing in several unique securities, money managers will build a portfolio that mimics a specific index: the S&P 500, the Dow Jones Industrial Average (DJIA), the NASDAQ—to name a few. In buying stocks that correspond with a single market index, index funds will produce returns similar to the entire index. As a result, these investment vehicles are best left for passive investors who want to match the overall market’s returns

Key Differences Of Index Funds Vs. Mutual Funds

A few key differences fuel the mutual fund vs. index fund debate, but the most prominent difference is how each chooses to invest in securities. Whereas index funds focus solely on specific indices (like the S&P 500 and NASDAQ), mutual funds are less limited. Instead of investing in a single index, mutual funds meet their own benchmarks by investing in an ever-changing list of stocks.

By investing in a single index, index funds strive to achieve market-average returns. On the other hand, mutual funds attempt to beat the market by handpicking individual stocks they think will outperform the rest of All Street. As a result, index funds are typically safer and easier to predict, but they don’t have the same upside as their mutual fund counterparts. That’s not to say one is better than the other, but rather that each serves a unique purpose for investors at different places in their investing careers.

The biggest difference between index funds and mutual funds is the securities they choose to invest in. That said, there are other key differences of index funds vs mutual funds, not the least of which include:

• Management

• Objectives

• Costs

Active Vs. Passive Management

One of the key differences between mutual funds and index funds is how they are managed. For example, index funds use algorithms and automated systems to simulate the same holdings of a particular index. In other words, index funds use a passive management strategy determined by the index it is mimicking. No money managers are making tough decisions on which securities to buy. Instead, automated systems match the exact holdings of a particular index, hence their passive nature.

On the other hand, mutual funds are much more involved in the securities they choose to invest in. As a result, mutual funds are actively managed to reach a predetermined benchmark. Instead of relying on automated systems, mutual funds will assign money managers who actively pick the best stocks for the fund and its respective clients. Means money managers are constantly investing in different stocks to achieve their goal.

Investment Goals

The goal of an index fund is simple: to mimic the returns of a single index. In attempting to replicate a particular index’s returns, index funds are usually more predictable and less susceptible to risk over longer periods of time. It is worth noting, however, that index funds do not offer the same upside as mutual funds. In replicating a single index’s returns, index funds seek to mitigate risk and provide modest returns.

Mutual funds seek to outperform the market. While investment goals vary significantly from mutual fund to mutual fund, the ultimate goal is to produce returns that trump the market average. In doing so, money managers will select specific stocks they believe can outperform entire indexes. Mutual funds have the potential for higher returns than index funds, but they expose investors to more risk.

Differences In Cost

Not surprisingly, the unique services associated with mutual funds and index funds call for different costs. That said, mutual funds have become synonymous with much higher costs. The active nature of mutual funds requires more resources: investment manager salaries, bonuses, employee benefits, office space, and marketing materials. Simply put, a lot more goes into mutual funds than index funds, which means they are required to charge investors more. According to NerdWallet, a mutual fund’s average management fee is somewhere in the neighborhood of 0.82%. While that may not sound like much, it’s almost ten times more than what index funds charge. The average expense ratio for an index fund is 0.09%, according to NerdWallet. The discount is the result of the passive management style.

Summary

It is not uncommon for an investor to compare mutual fund vs index fund opportunities. Both investment strategies have proven they belong in a diversified portfolio but serve different purposes. For example, index funds are better for those who want to mitigate risk and generate modest, predictable returns over long periods of time. On the other hand, mutual funds expose investors to slightly more risk and cost more to invest in, but have the potential to result in market-beating returns. Which one investors choose to invest in is entirely dependent on their own goals.