Index Funds Vs. Mutual Funds: the Main Differences

  • Index funds and mutual funds allow you to invest in a variety of stocks, bonds, and assets.
  • Mutual funds are actively managed by an investment professional, while index funds they are more passive.
  • mutual funds have much higher fees than index funds, which can reduce your potential earnings.

For many novice investors, the idea of ​​picking stocks by hand can seem quite daunting. Fortunately, with tools like index funds and mutual funds, that kind of legwork isn’t really necessary to start your investment journey.

Here’s what you need to know about these investment vehicles and when you might want to invest in them.

Reading: Index fund vs mutual fund difference

what is an index fund vs. a mutual fund?

Both index funds and mutual funds allow you to invest in a variety of assets without having to pick those investments one at a time. the main differences are how those funds are managed and their earning potential.

These are the basics of both types of funds:

  • an index fund is a group of investments whose objective is to mimic the performance of a certain market index, often the s&p 500, the dow jones industrial average or the composite nasdaq (although there are many more). investors buy shares in the fund and see profits when the shares within the fund increase in value.
  • a mutual fund is a company or fund that invests in a variety of assets, including stocks and bonds. Investors can then buy shares of the fund, thus buying a stake in all the companies within that portfolio. Unlike index funds, mutual funds are actively managed, which means a professional monitors the performance of the portfolio and makes purchases and trades within it on a regular basis.

According to Matthew Willett, investment advisor with Wealth Plan Advisors in Scottsdale, Ariz., both funds offer baskets of securities, in which investors can buy shares.

“Instead of buying shares of many individual companies, investors can buy shares of a fund made up of hundreds or thousands of companies,” says Willett. “As companies within the fund increase or decrease in share price, the value of investors’ shares in the fund will change in the aggregate.”

what is an index fund?

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An index is a type of mutual fund or ETF that aims to match the returns of a given index. The S&P 500 is one of the most widely used indices, but there are many others as well, including the Wilshire 5000 Total Market Index, the Russell 2000 Index, and the Dow Jones Industrial Average.

With an index fund, money is invested in securities within the aligned index, sometimes all of them, sometimes just a sample. the ultimate goal is to mirror the performance of the overall index and offer similar returns to fund investors.

Investors typically earn a small percentage per year. Based on 2020 data, the S&P 500 has returned 13.6% annually for the past 10 years. historically, annual return has averaged 9.2%.

Because index funds do not require regular trading or sales, they are considered passive investments and are not actively managed by a professional. This means that fees are lower on these funds than other investment vehicles, particularly when compared to actively managed mutual funds.

“An index fund would be best for someone who doesn’t have a lot of money and is just starting out,” says Josh Simpson, vice president of trading and investment advisor at Lake Advisory Group. “This would allow them to achieve diversification with their investment without having to spend hours learning how to invest.”

example of an index fund

The Vanguard 500 Index Fund is the first index fund in existence. the fund tracks the s&p 500 index and contains shares of all 500 companies that comprise it. it has generated an average annual return of 7.84% since 2000, just below the index average for that period.

what is a mutual fund?

Mutual funds, like index funds, invest in a variety of stocks, bonds, and other assets, they just aren’t trying to follow the market, they’re trying to beat it. Mutual funds come in several types, including money market funds, bond funds, target date funds, and stock funds (index funds fall into this category).

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Most of these funds (other than index funds) are actively managed, meaning an investment professional will regularly buy and sell shares within the portfolio in an effort to maximize returns. While this opens the door to higher potential returns than index funds, it also means returns are unpredictable.

Quick tip: Actively managed funds have higher fees than passive funds (such as index funds). According to the Institute of Investment Companies (ICI), the average commission of variable income mutual funds is 1.16%. in index funds, it is only 0.58%.

“The reason someone would choose an actively managed mutual fund is that if you can identify a fund manager who can consistently beat the market, you can amass enormous wealth,” says Robert Johnson, president and CEO of economic index associates and a professor of finance at creighton university. “For example, investors who invested in the Magellan Fidelity Fund during the time Peter Lynch ran it earned an average of 29.2% during the time he ran it, more than double what the S&P 500 earned during that time.” time”.

However, those types of earnings are not guaranteed. And, in many cases, actively managed funds actually underperform the market. According to data from the S&P Dow Jones Indices, 82% of large-cap funds underperform the S&P 500 over a 10-year period.

example of a mutual fund

Let’s say you plan to retire in 2045. If you want to maximize your available cash by then, you might consider a 2045 target date fund, an actively managed mutual fund with a set end date. To participate, you would buy shares of the fund, along with other investors looking to retire at the same time, and your fund manager would buy and sell assets to help you reach your goal by the target date.

the end result

Both index funds and mutual funds can help you achieve your financial goals, but through very different approaches. With one, you’ll enjoy a hands-off, passive investment that delivers consistent returns. with the other, you’ll get an actively managed fund that, in some cases, could beat the market.

If you’re not sure which is best for your goals, talk to a financial planner. In many cases, both investment vehicles may be the right choice for your long-term wealth.

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