When you start investing, it’s easy to get confused by the different terminology. Index and mutual funds are two you might have come across in your learning.
Simply put, index funds track an underlying market index, like the S&P 500, whereas mutual funds are managed financial vehicles that invest in stocks, bonds, money market instruments, and other securities.
What is an index fund?
An index fund is a type of mutual fund or ETF that automatically tracks the performance of an underlying market index, such as the S&P 500. Index funds follow a passive investment strategy, whereby the investor can simply invest their money and then forget about it.
What is a mutual fund?
Mutual funds are operated by fund managers and consist of a group of investors who mutually pool their money together to buy and sell stocks, bonds, and other assets. When you invest in mutual funds you are not buying shares in a specific company. Instead, you are buying shares in the mutual fund company itself.
Differences between Index Funds and Mutual Funds
Although an index fund is indeed a type of mutual fund, there are three key differences between index funds and more actively managed mutual funds — the management of the fund, its investment objective, and the associated costs.
Index funds are usually passively managed as the fund is simply tracking an index. It performs by buying and selling securities to mirror a particular index, such as the S&P 500. The performance of an index fund is measured by the price movement of the shares within the fund.
Other mutual funds are actively managed, so its performance rests on the investment decisions made by the fund manager. However, SP indices stated that within five years, almost 80% of actively managed funds underperformed the S&P 500 index, proving that mutual funds don’t necessarily yield better returns.
The goal of an index fund is to copy the performance of an index, whereas other mutual funds aim to outperform it by selecting assets that they think will yield bigger returns. Many investors are attracted to mutual funds by the prospect of higher-than-average returns on their investments.
Mutual fund expense ratio is the name given to the extra expenses associated with running mutual funds — including fund manager salaries, marketing costs, bonuses, and other fees. Fund managers’ fees cut into investors’ profits, so should be carefully considered.
Index funds have fees of around 0.05% to 0.09%, much lower than mutual funds, which are usually between 1 to 2%.
So, why would I pick Index Funds?
Index funds are suited towards long-term investment and make great picks for retirement funds as they are considered the safer of the two funds. They are great for diversifying your portfolio without having to make separate investments into different companies. Index funds are great core portfolio holdings as they are a lot easier to invest in and out-perform actively managed funds time and time again.
The main benefits of index funds are lower fees, fewer taxes to pay (as there is less turnover in stocks), and tend to be less risky for long-term investment.
And Mutual Funds?
Mutual funds are a great way for smaller investors to have access to professionally managed funds that are very diversified. Mutual funds are great for flexibility in moving assets around, potentially higher returns, and the ability to capitalize on short-term gains. The risk is higher with mutual funds, but so is the possible reward.
How will I choose?
There are many factors to consider when deciding between investing in index or mutual funds – available capital and investment aspirations being the top.
Before taking on any type of investment, it is very important to consider the structure, objective, and costs associated with that fund. It all comes down to your investment risk attitude and financial goals though, so do your research, and don’t forget there is always the DIY approach too, and select your stocks.
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