For a newbie in investing, the concept of choosing individual stocks yourself might seem intimidating. Luckily, with mutual funds and index funds, life is made easier.
This article discusses what you need to know about these two investment options — the differences and why you might want to invest in them.
What are Mutual Funds?
Mutual funds are a type of fund that pools money from different investors to invest in different assets. It helps the investors spread their funds across hundreds of companies instead of just a few.
Investors buy and sell their units in mutual funds at a price set at the end of a trading period. Mutual funds can offer high returns if managed properly. Several options are available to help you meet your investment goals. You can begin here.
What are Index Funds?
An index fund is a portfolio of stocks designed to imitate the structure and performance of a financial market index like the S&P 500 or Russell 2,000. An index fund is also a type of mutual fund.
Index funds are a form of passive investing. Investors don’t need to actively manage the stocks, and this is what makes them different from mutual funds.
Read more about Index Funds.
| # | Mutual Funds | Index Funds |
| 1 | Actively managed by professionals, which makes them more expensive. | They are based on an index, so they tend to be cheaper and passively managed. As a result, they charge lower expense ratios to the investors. |
| 2 | Have higher tax returns because they have higher capital gains. | They offer low tax liabilities for the investors because they have lower turnovers. |
| 3 | You enjoy the benefits of diversification and reduced risks. | Index Funds offer diversification but not as much as mutual funds. |
| 4 | Mutual funds have been around much longer. | Index funds only became popular some decades ago around the 1970s. |
Mutual Funds vs Index Funds: Management, Investment objectives and costs
Besides the distinction seen from the definitions above, there are three differences between mutual funds and index funds. These differences are in investment management, objectives and costs.
Active vs Passive management
In mutual funds, the investors choose a professional to help them select the funds holding. The professional has the skill and experience to decide which shares to buy or sell and makes decisions to increase returns.
The overall goal of the professional is to beat market returns. This makes mutual funds more expensive because the professional must be paid for their effort for active management.
Unlike mutual funds, index funds are passively managed and do not require as much attention. The investors do not try to beat the market but instead replicate the performance of the market.
Investment objectives
Index funds tend to be less risky and are purchased mainly by people interested in smaller low-risk investments who do not have the time to actively track the market.
Mutual funds are a more attractive bargain to investors because they tend to increase the value of securities such as bonds and other stocks over time. Depending on your goals, mutual funds, if managed well, can help you build wealth long-term.
Investment fees/Expense ratio
An expense ratio is the amount of money that investment companies charge investors to manage their portfolios. It’s basically the operating cost and management fees.
In index funds, the typical expense ratio could range from 0.2% but can be as low as 0.02% or less in some instances and is about 0.5% to 0.75% in an actively managed fund.
Bottom Line
Both mutual funds and index funds can help you reach your financial goals. One is great if you don’t have the time to track your investments regularly; the other is actively managed and can get you steady returns.
Finally, seek advice from a financial counsellor and read up on personal finance books and other valuable resources to help you have a clear path on your investing journey.
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