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Comparing Index Funds Vs Mutual Funds

Breaking Down Index & Mutual Funds

With an overwhelming amount of information floating around the Internet and thousands of brokerage firms offering to invest your money, it can be difficult to understand all the different types of funds. We’re here to help you learn just about everything you need to know about index funds vs mutual funds, and to break down these two popular investment vehicles.

By the end of the article, you’ll be in a much better position to make an informed decision about whether or not index funds or mutual funds are the right choice for you.

Index Funds vs Mutual Funds. What’s The Difference?

In simple terms, the main difference between index funds and mutual funds is that an index fund attempts to keep pace with a broader market by investing in a particular collection of securities known as an index. Mutual funds, on the other hand, seek to outperform the market by selecting the most profitable securities and avoiding losing ones, and actively executing trades on a frequent basis.

Let’s take a look at some of the defining characteristics of index funds, and what makes this popular investment choice unique.

What Are Index Funds?

When index funds were first introduced in the 1970s, industry professionals sneered at the idea of believing it would yield mediocre returns. Clearly, they were mistaken. Today, index funds account for almost half of all money invested in the stock market, and their popularity only seems to be increasing.

Index funds are funds designed to match the performance of a particular market. You’ve probably heard of the FTSE 100, which is an index that tracks the performance of the 100 largest publicly-traded companies in the UK.

But there are also index funds that follow sectors, commodities, municipal bonds, and more.

How Do Index Funds Work?

Index funds are designed to move with the market or asset class they’re tied to. Let’s take a look at the Russell 2000 Index as an example.

While the S&P 500 tracks large-cap stocks (over $10 billion market capitalization—think Apple, Microsoft, Ford, Johnson & Johnson), the Russell 2000 Index is a benchmark for small-cap companies with a market capitalization between $300 million and $2 billion.

When the collection of small-cap stocks in the Russell 2000 are doing well as a whole, the Russell 2000 index fund will go up. So, even if some companies are performing poorly and losing value, as long as the aggregate of these companies is positive the index will overcome the losses and continue to climb in value.

How To Invest In Index Funds?

Thanks to the ubiquity of the Internet, index funds are easier to trade than ever, which can be done in a matter of minutes from your home, office, or just about anywhere else.

Vanguard, (whose founder Jack Bogle is often credited with inventing the index fund) is currently the second-largest asset management company in the world, and offers a multitude of index funds that you can invest in, depending on the fund.

Everything You Need To Know About Mutual Funds

Modern mutual funds preceded index funds by half a century, and many investors across the world continue to put their money in mutual funds. Here’s some more information on how mutual funds work, how to invest in mutual funds, and what sort of returns to expect from this type of investment.

What Are Mutual Funds?

Mutual funds are investments that are centred around a group of clients who pay a fee to professional investors to actively manage their money.

The modern mutual fund dates back to 1920s Boston, when the Massachusetts Investors’ Trust opened a mutual fund to investors. Mutual funds emphasize deep analysis, research, and taking the risk of picking and trading individual securities in hopes of generating lofty gains.

How Do Mutual Funds Work?

Mutual fund managers are continually conducting extensive research on the market, trends, and specific companies, attempting to hand-pick the individual winners.

In doing so, these money managers believe they have key information and data that will allow them to sift through a large number of stocks and choose the individual securities that will outperform the market.

The basic idea behind mutual funds investing is that an expert on the market will be better equipped than the average person to predict which investments will thrive and which ones won’t.

However, the reality of mutual funds is similar to most things in life — sometimes you win, and sometimes you lose. Mutual funds offer investors the prospect of faster and greater returns but come at the risk of greater and faster losses.

What Are The Average Rates Of Returns For Mutual Funds?

Mutual fund performance depends entirely on the portfolio of the fund manager, and can vary significantly from year-to-year.

Analysis of mutual fund performance shows that the majority of fund managers actively selecting stocks failed to outperform benchmarks 65 percent of the time, while bond fund managers fell short 73 percent of the time.

So, while some fund managers have impressive track records that may top the indexes like the S&P 500, these results cannot be expected.

How To Invest In Mutual Funds.

First, you’ll want to decide how much money you’re comfortable investing.

Once you’ve done that, it’s time to start searching for a money manager. Some people prioritise investing with an individual they trust—a friend, family member, or referral; others value a company with a strong reputation.

Regardless, there are many brokerage firms out there that would happily accept your investment in their mutual funds.

So, What’s The Difference?

The most notable difference between mutual funds and index funds is that index funds tie themselves to the market in a passive effort to consistently generate solid returns through passive investing, while mutual funds swing for the fences by actively picking the securities they believe will beat the market’s average returns.

Read more: 5 Passive Income Ideas That Actually Work In 2019

What About Fees?

Both index funds and mutual funds charge a fee to cover the administrative and operating expenses incurred in providing its services; these fees are charged as a percentage figure of the amount of money you have invested.

Index funds typically charge a relatively low fee, ranging from 0.05% to around 0.11%.

Mutual funds, on the other hand, tend to charge a much higher fee, ranging from 0.5 percent to as much as 3%, with an average falling somewhere in the 0.84% range.

It Depends On Your Objectives

As mentioned earlier, index funds assume the role of a passive investment. Index funds seek to let the market take its course, and its fate is connected directly to the performance of the market of the particular securities included in that index.

The objective of mutual funds is to turn an even greater profit than the market, and to skip out on investing in the market as a whole by actively attempting to buy winning shares and avoid losing securities.

Returns—What to Expect

Index funds are a great way to (just about) guarantee a profit over a long period of time, barring any kind of global meltdown or alien invasion.

Let your money sit in a broad index fund and it’s a low-risk way to grow your retirement if you give it enough time.

Over ten-year periods equities have made as much as an annualised +12.4% to -3.5% a year after inflation. As an investor, making money from the FTSE 100 is dependent on capital returns from share price appreciation and income returns from dividends.

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Mutual funds intend to beat that number, and with an average fee of around 1%, mutual funds have to stretch just to keep pace with the returns on index funds.

Unfortunately, gauging returns from mutual funds isn’t all that simple since results can fluctuate tremendously depending on the money manager and the firm’s picks in a given year.

Why Choose An Index Fund Over A Mutual Fund? Advantages Of Index Funds

Many people choose index funds over mutual funds, and with good reason. Index funds are a great investment vehicle for the average person.

Index funds are easy to understand, keep fees at a minimum, and can generally be depended upon to put your money to work and yield a decent return on your investment.

While a mutual fund charges higher fees and relies entirely on selecting winning securities and avoiding losses, index funds accept that there will always be losses, but that the market as a whole will continue to drive itself forward and profit.

Index funds minimise risk exposure and offer investors a safer, less volatile way to invest.

Disadvantages Of Index Funds

Index funds are certainly popular and effective, but there are still some disadvantages to investing your money in them.

Though proven historically profitable over an extended period of time, index funds always bear some losses and won’t outperform the market. While your money is still growing, index funds aren’t intended to yield rapid growth and market-crushing returns.

Index funds are often better suited for investors with time, since the approach is more of a longer-term one with a “slow-and-steady wins the race” mentality. For the same reason index funds are less volatile, they are also less versatile. With trades being made less frequently than with mutual funds, people might consider the money invested in index funds to be less liquid or accessible.

Why Choose A Mutual Fund Over An Index Fund? Advantages Of Mutual Funds

Mutual funds are considered to have a distinct advantage over index funds when it comes to the prospect of higher earnings in a shorter period of time.

In addition, individuals who like to have some flexibility and be able to move their money around more quickly may gravitate to mutual funds.

Finally, mutual funds have provide the assurance that someone is watching your money and actively trying to grow it.

Some people take comfort in knowing that their money is invested with people whose job is to know the market, mind your investments, and act accordingly.

Disadvantages Of Mutual Funds

Two of the most commonly cited disadvantages of mutual funds are high fees and increased volatility.

Regardless of the fund’s performance, your fees are going to be charged, and they are, on average, about 8x higher than index fund fees. Mutual funds also carry more risk, and while there is a chance to beat the market and scoff at the returns of the index funds, the likelihood of underperforming and falling short of the market is increased.

Statistically speaking, most individual stocks and bonds do not outperform the market.

So, while there are certainly those securities that are the home runs for investors, over a 10-year period, large-cap stock funds managed to oust the market and beat its performance.

The Bottom Line

Mutual funds and index funds are two incredibly popular avenues for investing in securities. You now know how each one works, some of the advantages and disadvantages of each, and which one might be better aligned with your investment goals. Of course, there are plenty of people who choose to diversify their portfolios and invest in both index funds and mutual funds—the choice is up to you entirely.

Tom
About author

Fully qualified CISI Investment adviser for 5 year. Managed UK private client portfolios.
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