What You Need to Know about Index Funds and Mutual Funds

On their surfaces, index funds and mutual funds may seem interchangeable. Both offer diversification of assets and are commonly invested in a basket of stocks that aim to meet a certain investment goal. However, there are many key distinctions that separate an index fund from a mutual fund – distinctions that may be crucial to your portfolio of retirement investments.

The Breakdown of Index Funds

Index funds invest in a specific list of securities, such as a Dow Jones Industrial Average or S&P 500 index, which track stocks based on certain factors. The Dow Jones is a qualitative index that tracks 30 blue-chip (meaning some of the largest companies in the country that are well-known and crucial to the US economy) industrial and financial companies in the United States. The index is used by the media as a barometer of the broader stock market and the economy.^[1] There are many other indexes that track different stocks or securities and have different criteria for companies to get added or dropped from them.

When it comes to an index fund, a broker will offer a fund that allows you to buy a basket of stocks that correlates to an index. Index funds may track the same index but differ in how each stock is weighted inside the fund. Some funds may also favor or screen out sectors or stocks with certain technical or fundamental traits to meet a specific investment goal.

Overall, Index funds simply track the market in some form or another with less of a focus on “beating” the market.

Mutual Funds

Mutual funds often invest in a changing list of securities chosen by an investment manager. Mutual funds may provide you with more diversification and a greater range of options, but index funds are often less expensive in fees. In addition, a mutual fund’s aim is to specifically meet an investment goal and to “beat” the market. In other words, mutual funds are actively managed funds, while index funds are passively managed, only really changing based on the stock index, not a manager’s decisions.^[2]

Over the course of many decades, index funds outperform mutual funds on average, especially when factoring in the fees charged. However, those fees may be worth it when specific investment risks are covered, and you benefit from increased diversification and flexibility.

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