Mutual funds and index funds are investment vehicles that make it easier for investors to build a diversified portfolio. Investors can buy shares in a single entity, which is the fund, to gain exposure to many of the securities in which the fund invests.
Differences Between Mutual Funds and Index Funds
Mutual funds provide investors with a way to gain exposure to many securities at once, while index funds typically aim to track the performance of a specific market index, such as the S&P 500. Some other mutual funds use different strategies in an attempt to outperform popular market indices.
Exposure to Many Securities
Both mutual funds and index funds offer investors an easy way to gain exposure to a variety of different securities. Mutual funds and index funds can be good options for investors who want to build a diversified portfolio easily, as these funds typically hold many different securities.
Investment Strategy
Mutual funds and index funds differ in their investment strategies. Index funds are a type of mutual fund that generally aim to match the performance of a specific market index as closely as possible. For example, if you invested in an S&P 500 index fund, it would attempt to replicate the performance of the S&P 500 index. There are many other types of mutual funds besides index funds, and each fund can have a different investment strategy.
Costs
Index funds are a type of mutual fund that is passively managed. Fund managers build a portfolio that mimics the one the fund aims to track, and then they work to maintain that portfolio. In contrast, active mutual fund managers spend a lot of time researching investment opportunities and trying to find advantageous times to buy and sell.
Tax Responsibility
Mutual funds distribute profits to investors who own shares, and these investors must pay capital gains taxes on the profits they receive. In contrast, index fund managers tend to engage in fewer transactions, which means index funds typically generate fewer capital gains. This means that index funds can create less tax liability for investors in the short term.
Which is Right for You?
In general, it is better to choose an index fund over an actively managed and more expensive mutual fund. Actively managed mutual funds have higher investment costs, which means that the fund manager must not only outperform the market but must also outperform enough to overcome the impact of the additional fees incurred.
Studies have shown that there are very few fund managers who can outperform the market over the long term, especially when adjusting results for fees.
Investments in mutual funds with specific strategies can be beneficial for investors looking to add very precise assortments of stocks, such as companies in a specific industry, to their portfolios. However, most long-term investors would be satisfied with an index fund.
Example of Mutual Funds vs. Index Funds
Suppose you invested $100,000 in two mutual funds. The first is a passively managed index fund, and the second is an active mutual fund trying to outperform the market.
The index fund charges an average industry expense ratio of 0.13%. The actively managed mutual fund charges a fee of 0.66%.
If both funds had a return of 10% in one year, after accounting for fees, your balances in each would be respectively:
Index Fund: (100,000 + (100,000 * 10%)) * (100% – 0.13%) = $109,998.57
Active Mutual Fund: (100,000 + (100,000 * 10%)) * (100% – 0.66%) = $109,992.74
Although the difference seems minor at first, the impact can be significant over the long term. Over 30 years, the extra fees of 0.53% paid to the active mutual fund will cost you $227,416.16, assuming both funds continue to yield an annual return of 10%.
To achieve
The same returns, an active mutual fund manager will need to outperform the index fund by 0.53% each year, which is a significant amount.
Conclusion
Index funds are a type of mutual fund that focuses on mirroring a portion of the market rather than trying to outperform it. They typically have lower management fees than active mutual funds, making them a good option for investors who are not looking for a fund with a specific strategy, such as focusing on a particular type of stock or sector.
The Balance does not provide tax, investment, or financial services, nor does it offer advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and may not be suitable for all investors. Past performance is not indicative of future results. Investing involves risks, including the risk of losing capital.
Source: https://www.thebalancemoney.com/mutual-funds-vs-index-funds-what-s-the-difference-5189229
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