Index Funds Versus Mutual Funds
How passively managed index funds and actively managed mutual funds differ, and how to choose the right mix for your goals.
Summary
Ron Tallou explains why index funds suit investors who want to take the guesswork out of buying, and how to weigh fees, taxes and track records when choosing between index funds and actively managed mutual funds.
Passively managed index funds and actively managed mutual funds are different ways to invest in securities and are suitable for people of all investing experience levels. When deciding whether to buy an index fund versus a mutual fund, you first need to define why you are investing, your goals, risk tolerance, time horizon and asset allocation.
What are index funds?
Index funds are found in both exchange-traded funds (ETFs) and, to a lesser extent, mutual funds. An index fund invests according to the structure of the index it follows, such as the S&P 500. Index funds seek to replicate the underlying index's return, minus the cost of administering the fund.
Ron Tallou, an investment adviser representative who's founder and owner of Tallou Financial Services, said that in addition to index funds that follow well-known indexes, some focus on niche sectors such as technology or financial services. These vehicles are passively managed, meaning the portfolio manager doesn't make active decisions with the holdings contained in the fund.
Because index funds produce relatively reliable returns, they are generally suited for investors who don't want to spend a lot of time researching the market, Tallou said.
"I would say an index fund is really excellent for somebody that just wants to put some money away and take the guessing out of the equation on what to buy. You just buy the overall market," he said.
What are mutual funds?
Many mutual funds are actively managed, so a portfolio manager picks securities and positions the portfolio around an indexed benchmark with an attempt to outperform the index. Active fund managers can take more, or less, risk than the benchmark index they follow.
Breaking down the costs
Passively managed index funds are cheaper than actively managed mutual funds because the index fund needs little hands-on fine-tuning. In an active fund, investors essentially pay managers for their skill in selecting securities.
Tallou said mutual funds also pass on capital gains at the end of the year to their owners, who must pay taxes on them annually. Morningstar data as of 2023 show investors’ average fund fees, regardless of investment strategy, were 0.55% for passive index funds compared to 1.01% for all active fund strategies.
Investing for your future
There's no one right answer whether to use index funds versus mutual funds. Tallou said he uses a mix of active and passive funds, which allows him to take advantage of the best these funds have to offer. Whatever mix you choose, don't forget to take fees into account.