Learning how to invest can be fun, but it can also be a little intimidating when you start reading about the various forms of investments, especially if the first book you pick up isn’t designed for a first-time investor. This article covers the differences and similarities between mutual funds and index funds, two of the more popular forms of investing that you have probably heard of, but you may not completely understand.
Comparing Index Funds and Mutual Funds
Both mutual funds and index funds are collective investments, which is an investment where investors pool together their money to make a collective investment they wouldn’t be able to make on their own. Collective investments often have a preset criteria they are trying to achieve, such as investing in a certain market or type of investment. This is an ideal situation for beginner investors who may not be able to fund a well-diversified investment portfolio with a small budget. Mutual funds and index funds have several similarities and differences, which are covered below.
Mutual Funds – Anything Goes
Active management. Mutual funds are professionally managed investment funds which pool together resources from many different investors with the goal of reaching the fund’s investment objectives through buying and selling the fund’s investments. Most mutual funds are overseen by trustees or board of directors which ensures that the funds are being managed properly and in the best interest of the investors. Mutual fund portfolios are monitored by the management company (usually called a portfolio manager). The goal of a mutual fund is to beat the market.
Types of investments. Investments in mutual funds are made in securities like stocks and bonds, money markets, other mutual funds, and/or commodities such as precious metals. Many mutual funds are created in a specialty or sector. For example, a specific mutual fund may only contain investments in a certain stock class (such as value stocks, dividend stocks, etc.), or a sector, such as technology, medical, financial services, utilities, commodities, etc.
Taxation. In some cases, mutual funds are not be taxed on income like most other business entities – provided the mutual fund distributes at least 90% of their income to their shareholders, and the funds meet additional IRS diversification requirements. Distributions from mutual funds including tax-free municipal bond income are tax free to shareholders, while taxable distributions from mutual funds can either by ordinary income or capital gains depending on how the fund earned the distributions. Net losses from mutual funds are not passed through to fund investors.
Index Funds – Mirror the Stock Market
Passive management. Index funds are designed to follow a stock market or other investing index and stick to a set of rules regardless of the current market conditions. Often, index funds rely completely on computer models without any human decision making as to which securities are bought or sold. Because of the lack of human input, index funds are considered a passive managed investment. The value of the index fund will fluctuate as the value if the index increases and decreases. The goal of an index fund is to match the market.
Types of investments. Index funds follow the structure of the index they match, so if the index is a stock based index, the index fund should contain the same stocks in the same proportion as the stock index. Index funds can be found for various types of investments including different stock classes, bonds, commodities, and other types of investments. Adding or removing stocks to the index usually only happens when new stocks enter or leave the index. Despite computer models and an attempt to replicate the index used as the model for investing, there is no way to make the investments 100% accurate. The difference between the index performance and the performance of your index fund is called the “tracking error” or “jitter.” Many investment managers offer index funds. Most use indexes from S&P 500, Nikkei 225 and FTSE 100. Some rely on educational research indexes like Eugene Fama and Kenneth French to develop asset pricing models.
Index funds are a simple investment. You pretty much always know what you will get with an index fund. And because there is a relative lack of human input, or a passive quality to index funds, they usually have an advantage of lower fees and taxes. They are have lower investment turnover, which can be beneficial at tax time.
The Difference Between Mutual Funds and Index Funds
The primary differences between an index fund and a mutual fund is how they are managed (active vs. passive) and which rules govern the type of investments made. Active and passive management usually result in higher or lower management fees. Mutual funds have an active management, and often higher management fees, and Index funds are typically passively managed and will mimic an index regardless of the market conditions. Because the criteria for index funds is more or less set in stone, the management fees are substantially lower than most mutual funds.
Which is better – mutual funds or index funds? When deciding which type of fund to invest in, you need to consider your investment goals, and the investment goals of the fund. If you are trying to minimize fees and maintain a simple investment, then an index fund may be a better option. If you are looking for an actively managed product and are you trying to beat the market, then you may want to consider a mutual fund.
Obviously, everyone want to beat the market if they can, but it doesn’t always work out that way. When researching mutual funds, keep in mind the types if investments offered by the fund, the fund manager’s history, the fund track record, management fees, and anything else that may affect your decision to invest. Also keep in mind that past results do not guarantee future returns. Here are more pros and cons of mutual funds.
Where to purchase mutual funds and index funds. You can purchase mutual funds and index funds through almost any brokerage firm and through some banks. This list of the best online discount brokerage firms is a good place to start.
Similar investments: See exchange-traded funds (ETFs), for a type of investment similar to a mutual fund, but different in how it is traded.