Mutual funds vs. index funds: What’s the difference?

Deciding whether you want to invest in mutual funds or index funds may seem like a really tough decision, like deciding between your favorite two desserts.

Of course, you could invest in both mutual funds and index funds — just like you could order both desserts — but regardless, there are some differences between both types of funds that can help you make an informed investment decision.

Let's go over the differences between mutual funds and index funds as you consider which is better for your personal portfolio and financial situation.

So, how does a mutual fund work? A mutual fund pools money from multiple investors and invests it into different securities. Think of the individual securities that make up a mutual fund as the ingredients for baking cookies — chocolate chips, baking soda, flour, butter, eggs.

Buying shares of a mutual fund means you purchase all the ingredients in the mixing bowl. In investing, it's often referred to as buying into a basket of securities — in other words, you become a shareholder of that mutual fund.

Mutual fund security types can include individual stocks, bonds, real estate or commodities (such as gold, beef, oil). Unlike purchasing individual stocks, in which you make all the investment decisions, a fund manager decides which securities go in the fund and how to buy and sell individual securities. In other words, it's not up to you to build these decisions into your investing.

An index fund is a type of mutual fund or exchange-traded fund (ETF). An index fund, also called an index mutual fund, is a bundle of stocks that mirrors the performance of an index, like the S&P 500, the Dow Jones Industrial Average (DJIA), the Nasdaq Composite or the Russell 2000 Index. Because index funds follows a specific index, they’re considered passively managed, and they also carry lower fees than actively managed funds.

Index funds can reduce short-term capital gains because index funds eliminate the constant buying and selling by active fund managers. However, active fund managers have the flexibility of choosing securities that give consumers the lowest tax bite.

Index funds can contain many, many underlying securities, which makes them more diversified and less volatile than individual stocks. By their very nature, index funds seek returns that match an index and can produce fairly predictable results over time.

Index funds generally don't pay capital gains to an investor until you sell the fund because they make few stock trades due to merely tracking an index. Index funds can, however, pay out dividends.

As with any investment, it depends heavily on what you want. Do you prefer active management to passive management? Do you want to pay fewer fees or more fees? Let's go over the pros and cons for you to consider.

Next, let's take a look at the pros and cons of an index fund.

The S&P 500 is not an active mutual fund or an index fund. It is a stock index that tracks the performance of 500 of the largest companies listed on stock exchanges, which refers to market capitalization of more than $10 billion. In order to invest in the S&P 500, you must invest in a fund that tracks it.

Which type of fund will work best for you and your specific investment needs? Actively managed funds or passive options? Do you have a specific index you want to track with your investment?

Before making an investment decision, consider your entire financial situation and what your objectives are with your investments. Once you have a full picture and better understanding of the differences between mutual funds and index funds, you’ll be better equipped to come to a conclusion that’s best for your portfolio.