People who are looking to start investing in the stock market are often confused about what are mutual and index funds. Both of these terms come under different categories: Mutual funds are a whole distinct structure of funds, while the index funds are a strategy used for investment. However, the two categories work together too at times. For instance, the index funds are sometimes made as mutual funds and a lot of mutual funds are index funds.
In simpler terms, index funds are used to keep a thorough track of the market index. Conversely, a mutual fund is a broad category that encapsulates different investment funds with a wide variety of investing strategies.
If you’re interested in earning a great fortune through stocks, read further to learn about the similarities and differences between index and mutual funds. You can use this knowledge later to make better decisions.
The Mutual Fund
The mutual fund is more about the formation or system of funds. Do not confuse this as an investment strategy. The mutual fund enables several investors to combine their funds by entering in a money pool to buy and sell stocks. Therefore, when one decides to invest in a mutual fund, they don’t trade shares of a particular corporation in that mutual fund, but they trade shares of the mutual fund company. Usually, the prices are set at the end of trading and so the investors buy or sell their shares according to the set price. The difference between mutual funds and single stock is that the value of shares in a mutual fund does not fluctuate during the trade session.
The Index Fund
Index Fund is a proper plan of action. A strategy that is followed while investing in funds. Index funds are used to keep track of the performance of market indexes like the Dow Jones industrial average or the S&P 500. Generally, in managed funds, investments are chosen by fund managers to come on top of the market. In contrast to this, index funds aren’t meant to beat the market, but to match it only.
Index funds are organized in a way to become mutual funds. The exchange-traded fund (ETF) is a prime example. As mentioned above, there is no fluctuation in the value of shares during a trade session in mutual funds, but the ETF holds a value that keeps changing due to public exchange in a trade session. In mutual funds, investors conduct business by trading shares of the mutual fund company, instead of buying/selling shares of a particular corporation, whereas the ETF investors do business with several other investors by buying or selling shares of the ETF itself.
Benefits Of ETF
ETFs can be traded all day, like common stocks. This particular option proves to be beneficial for people who look to buy and sell stocks quickly in the trade session. This is because they can take advantage of price movements that are taking place in the day.
If you notice the market is moving higher and the stocks are rising, this may be the best time to buy and ETF as you can take advantage of the trend.
Differences Between Mutual Funds And Index Funds
Apart from the general, superficial difference between the two funds mentioned above, there are other intricate distinctions as well. Investors have deep knowledge of the funds’ working and they use these differences to decide how to hold funds, what should be the goal, and the costs attached while investing in a fund. Here’s a list of these differences:
Essentially, index funds and mutual funds include stocks, bonds and different other securities. However, the index funds are purposed to track the stocks that have a lot of indexes like the S&P 500 or Nasdaq.
Two approaches present a dichotomy between the two funds. Most of the mutual funds follow the active approach or are managed actively. The fund managers need to be very quick and dynamic with their decision making in this case, and they do it on an hourly basis. Index funds, even those that are made as mutual funds or the ETF, follow a passive approach. Since this fund is used to track the performance of the market index, there isn’t any need for the fund manager to make quick decisions and actively manage it. Index funds, usually, only deal with the securities and stocks that coexist with the index they are tracking. As a result, investors do not have to buy and sell securities in regular successions.
In index funds, the fund’s performance relies only on the movement of the price of the shares included in the fund. This is because there is no fund manager actively supervising the index fund. Whereas, in the case of mutual funds, the performance depends on the investment decisions put forth by the fund managers. Fund managers have all the authority to select any security that is in-line with the investment goals of the fund.
If you’re wondering which fund is better, the answer lies in the statistics provided by SP indices recently. They showed that around 79% of big funds failed to perform well in the last 5 years. This goes on to show that despite high volatility in the market, due to a plethora of events happening in recent years, active funds aren’t performing well.
The other most significant difference is the goal each fund aims for. As for Index funds, the objective is to reflect how a particular index is performing. Conversely, in mutual funds, the main aim is to come on top of the market. Fundamentally, the funds that follow the active approach carefully choose investments that will guarantee a good return in comparison with the market. Consequently, investors that are looking for high returns will most certainly opt for mutual funds. However, the actively managed funds cost more than their counterpart because they require a lot of work and managers to supervise the fund on regular basis.
- Costs Incurred
Now that we have established how the two funds work, no doubt actively managed funds will cost more than the funds that follow a passive approach- index funds. The reason being, actively managed funds come with an abundance of different expenses like manager’s salaries and bonuses, setting up a proper workplace where they will work, promotional activities, and various other overhead costs. In recent times, the shareholders use a mutual fund expense ratio to mop up all these costs. This ratio is calculated by dividing the total value of assets in the fund by the total fund fees – that includes management and operating expenses. Generally, the expense ratios for mutual funds lie in the range of 0.1% to 2.5%.
What most investors fail to consider is that the higher the costs incurred in the investments, the lower will be the returns. So, if you’re thinking to purchase shares of mutual funds or actively managed funds to enjoy greater returns, bear in mind that there will be high chances of low performances.
The index funds come with a fee as well, but it is very low as compared to the mutual funds. This is why index funds are usually more successful because the management fees are very low, and this yields better returns.
In A Nutshell
Mutual funds and index funds follow a different approach, but some mutual funds are index funds. As explained above, index funds are to track the market index to reflect on their performance. For people who find it risky to invest in single stocks, where everything has to be managed by the individual, mutual funds and index funds are great options. However, it is very important to have a thorough knowledge of either type of funds; how they work, what are their objectives and goals, how much does each cost, and what are the expected returns. Considering the fees attached with both the funds is imperative, because a general rule of thumb states, the higher the fees, the higher the chances of a drop in returns. If you’re still feeling the need to know before you splash in your money, consult a financial advisor.
Both the funds come with a different set of benefits. Mutual funds offer better flexibility in transferring your assets because of their active nature. Fund managers can hedge positions and move assets easily. Mutual funds offer higher returns. Lastly, for people who seek to enjoy short term profits, mutual funds are the best option for them because fund managers have the authority to trade and make the most of every potential short-term gain, which may not be the case in index funds.
Index Funds come with lower fees and taxes. Secondly, you can get attached to large scale stocks without directly investing in them. Most importantly, for people who have the patience to earn better in the long-term should choose index funds as they can buy the funds and be relieved. There is no need to track and check every particular stock or index on daily basis.
Important Tips For Investing
Doing extensive research on the topic of stock markets can prove to be beneficial before you invest, but it is better to take suggestions of an expert in the field along with your research. Consult a financial advisor who can guide you about mutual funds and index funds, and advise you what suits your needs the best.
If you are willing to invest a smaller amount, you should go to online brokers or Robo-advisors. They operate online and offer affordable fees and account minimums.