5 differences between index funds and mutual funds I'm glad I finally know

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• I decided to ditch all of my individual stocks in favor of index and mutual funds.
• However, I was curious: What exactly is the difference between an index and a mutual fund?
• The biggest differences seem to be how much they cost and how they are managed.

My journey as an investor started only a few years ago. After repairing the damage I did to my finances during my 20s, I entered my 30s on a mission to make smart decisions with my money. Once I built up my savings account, emergency savings account, and retirement fund, I decided it was time to invest in stocks.

I started buying stock in random companies I was interested in and before I knew it, I had a few thousand dollars invested in over 20 individual companies. That was a big mistake. I didn't know what I was doing, and wasn't keeping up with the market to know when to buy more or sell.

In an effort to move away from investing in individual stocks, I wanted to put money in low-cost index funds or mutual funds. The problem was, it seemed too confusing to even know where to begin. That's why I asked financial experts to explain the main differences between index funds and mutual funds. Here's what they had to say. 

1. An index fund can be a mutual fund

Even though it might sound confusing, Clayton Wood, a financial planner, says a good first step is understanding that an index fund is a mutual fund, but a mutual fund is not always an index fund. 

"A mutual fund is the pooling of money from multiple sources to invest in a bucket of investments usually managed by an asset manager,"says Wood. "A mutual fund's investments are guided by its Investment Objectives, which are found in the prospectus of the fund."

So how is an index fund different from a mutual fund? Wood says that an index fund is the pooling of money that invests in a portfolio that tracks an index, like the S&P 500. "The investment objective of the index fund is to mirror the investments and allocations of the index that is chosen," said Wood.

2. Index funds have lower expenses 

When it comes to fees, Alvin Carlos, a financial planner, says that index funds are low-cost mutual funds.

"It's the Costco of investing," said Carlos. "Index fund fees can be 10x lower than an averagely-priced mutual fund. Also, Index funds can give you better returns compared to a mutual fund."

"Studies show that you can make more money by investing in low-fee index funds compared to higher-fee mutual funds," he added. "More than 82% of mutual funds underperformed an S&P 500 index fund over the last 10 years."

3. They have different themes 

Depending on the risk you'd like to take, and how much you'd like to diversify your investment portfolio, Jay Kirkwood, a financial planner, says that it's good to know the different themes of index funds versus mutual funds.

"An index fund will track a specific index of stocks. You may be familiar with some, such as the Nasdaq, S&P 500, and the Dow Jones," said Kirkwood. "Other mutual funds may focus on a specific theme such as emerging markets and growth stocks."

4. Mutual funds are managed by professionals 

If you're looking to have a professional in charge of your investments, Amy Richardson, a financial planner with Schwab Intelligent Portfolios Premium, said that mutual funds are managed by professional money managers at brokerage firms — for a fee.

"With actively managed funds, managers invest with the goal of beating a benchmark. Costs of actively managed funds are typically higher given the potential for outperformance," said Richardson. "Most actively managed funds are mutual funds, but there are also many index mutual funds."

5. Mutual funds experience capital gain distributions 

One of the biggest differences between mutual funds and index funds is when taxable events occur for each.

"Mutual funds experience capital gains distributions which is a taxable event to an investor (even if the shareholder has not sold any of their shares) while ETFs typically do not," Richardson explained. "Mutual funds are required by law to make capital gains distributions to shareholders."

"The distribution represents the net gains from the sale of the investments throughout the year in the fund," she added. "Since ETFs are typically passive investments that track an index, an investor typically does not realize a taxable event until they sell their investment."

This article was originally published in February 2022.