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Index Funds Vs. Mutual Funds – The Differences You Need to Know!

When you are starting out as an investor, getting involved in mutual funds or index funds is the ideal choice. This is because this type of investment comes with a reduced degree of risk, and provide asset diversification. In addition to this, making an investment in an index and mutual funds is relatively easy, as it does not require a lot of money, to begin with. Hence, you are provided with the liberty to dip your toes in the investment pool, before making a large commitment.

While index and mutual funds may appear to be quite similar, they have several differences that you need to know about. To learn the difference between index funds and mutual funds, refer to the ensuing guide.

What is an Index Fund?

An Index fund falls in the category of mutual funds, or Exchange Trade Funds (ETFs), which holds all, or a representative sample of securities in a specific index. Index funds are designed to be parallel to the portfolio of a financial market index, such as Standard & Poor’s (S&P). To invest in an index fund, you need to open a brokerage account. Some index fund providers will also let you open an account with them to buy their index fund, e.g. Vanguard.

With an index fund, you are able to attain a broader market exposure and experience at a reduced cost. Additionally, this type of investment comes with a low portfolio turnover.

An index fund abides by a specific benchmark index, even if the state of the market fluctuates. Due to this reason, Index funds are popular as the perfect portfolio for retirement accounts, such as the SIPPs, IRAs (Individual Retirement Accounts), the 401(k) accounts and even ISAs.

The Objectives of Index Funds

The primary objective of the Index fund is to mirror the composition and performance of the financial market index. Hence, it focuses on using similar financial instruments as the market, and make an attempt to carry out a similar performance.

Types of Investment

In an index Fund, you can invest in stocks, bonds and other securities. When you make an investment in an Index fund, you are ultimately buying stocks that are engineered to track a specific index. This suggests that if you purchase shares of an index fund, you indirectly become the owner of the shares of stocks in a plethora of companies.  Investing in index funds is much better than investing in separate bond as it reduces the operating costs, and eliminates the need for the perpetual studying of the earning reports, generated by different companies. Hence, index funds are ideal for individuals who lack the analytical skills required for stock investment.

In a stock index fund, the nature of the investment varies. Your investment could either hold a small number of stocks or it could hold a large number of versatile stocks.

Similarly, you can also invest in index-related products, such as a bond, which can be traded through a broker. Index funds also encourage investment in other commodities, aside from stocks and bonds. If you are investing in an index fund, you can place your money towards real estate investments and other commodities.

Advantages of Index Funds

Index funds have several advantages. In fact, it is the most recommended method of investment by Warren Buffett, who is one of the most successful investors of all time. If you invest in an index fund, you can enjoy the ensuing benefits:

  • In an index firm, you can reduce the likelihood of encountering a loss, as your portfolio becomes instantly diversified.
  • As index funds are passively managed, the expense ratio is around 0.03%- 0.07%. This number ensures that you are able to cut down on the costs in this method, especially if you are in it for the long term.
  • Index funds typically have high returns, despite offering a low cost. As a result, they are extremely valuable for investors.
  • Index funds are passive way of investing and do not require day to day management of funds.

What is a Mutual Fund?

A mutual fund is an aggregation of investments that belong to a pool of investors. This amount is handled by an expert money manager, who supervises the fund on a daily basis. This individual, using their experience, make the executive decision to purchase or sell investments, in accordance with the investment objectives of the fund.

Once you invest in a mutual fund, you essentially place your money in the pool of investments.  In doing so, you buy the units or shares of that specific fund. Similarly, when more people invest, the fund increases its units or shares.

The Objective of Mutual Funds

The primary objective of a mutual fund is to remain attentive towards a particular category of investment and establish the types of securities it buys. Hence, a mutual fund can invest in bonds, stocks in organisations, stocks in countries, along with real estate.

Types of Investments

Traditionally, there are four broad categories in which mutual funds can fall into.

Stocks

In this type of mutual funds, you invest in stocks of an aggregation of publicly trading companies. These funds experience a greater potential for growth while having low sensitivity in terms of its value.

Bonds

When it comes to investing in mutual bond funds, you place your money in government and corporate debt. Hence, bonds are relatively safer investments, in contrast to the stocks. With that said, this option has a comparatively lesser potential for growth.

Money-market funds

Money-market funds are considered as one of the safest forms of investment, as they offer a short-term liquid investment. These are fixed-income mutual funds, in which you place your money to cover the short-term debt from governments, banks or corporate institutions. In money-market funds, you invest in cash or cash equivalents securities, which are referred to as “money-market instruments.”

Hybrid funds

Hybrid funds are a combination of bonds and stocks. In this type of investment, you can have a fixed ratio of bonds and stocks. For instance, you can attain a 50% investment in bonds and a 50% investment in stocks. Hybrid funds are deeply advantageous, as they reduce the risk factor (which is high in stocks) and offer a higher return (which is lacking in bonds). This suggests that hybrid mutual funds combine the benefits of investing in stocks and bonds.

Advantages of Mutual Funds

Mutual funds offer a series of advantages. Majority of the investors choose this option, as a result of the following benefits.

  • To manage mutual funds, you pay an expense ratio to get your portfolio managed by a professional. This ensures that they make educated decisions on your behalf, which ultimately reduces the risks of making a bad investment.
  • Investing in mutual funds facilitates diversification. As a result, you can experience a reduced portfolio risk.
  • Investing in mutual funds is relatively easy. This suggests that mutual funds are a convenient option for making an investment.

How are they managed – Index Funds Vs Mutual Funds?

The fundamental difference between index and mutual funds relates to the way in which they are managed. Index funds are passively managed, whereas, mutual funds are actively managed.

Mutual funds, being actively managed, have a fund manager, who has experience in the industry. The role of the fund manager revolves around making thoroughly planned decisions related to the investment of money. In actively managed funds, the managing team narrows down the reliable options for investing money and considers different ways to wisely handle the financial assets.

On the contrary, index funds are passively managed. This means that they do not have a team of experienced fund managers to make investment decisions. In contrast, index funds follow its main objective of imitating the market index.

Actively Managed Funds

Actively managed funds have several benefits, as well as some drawbacks. With an actively managed fund, you have the opportunity to beat and surpass the market index. In addition to this, you can also attain larger returns from an actively managed fund.

With that said, actively managed firms only perform well, if the right investments are made. Considering this, if your fund manager fails to comprehensively examine the firm’s financial history, you could experience more losses than gains. Moreover, with an actively managed fund, you are also obligated to pay the management fee, regardless of how well your fund is doing. This means, that if your investment experiences a poor performance, you would still be required to pay your percent of the fee, thus losing more money.

Passively Managed Funds

Passively managed funds are a safe and dependable choice. This form of investment is ideal for investors, who are okay with placing their money in for an elongated period of time. Therefore, if you have excess money, which will not be in need for some time, passively managed investment opportunities can be ideal for you. In addition to this, passive management also provides you with a degree of transparency. You can review where your money is, what it is doing, as well as the fluctuations of the market. In actively managed funds, you do not have this luxury.

However, passive fund management has some disadvantages, you can avail limited returns, as your money only mimics the market. Considering this, there is no opportunity for you to beat the market’s threshold.

Costs of Index Funds and Mutual Funds

The overall cost of the fund is determined by its expense ratio. The expense ratio is the total amount that is acquired by an investment company, which manages the investment portfolio or the mutual fund.

To calculate the expense ratio, you are required to divide the total operating expenses with the average value of the fund’s assets.

The expense ratio is the primary cost of managing an index or mutual fund. In the case of the former, you are charged a reduced amount, whereas, in the case of the latter, the charges are relatively more.

In the case of the index fund, investors are usually charged an expense ratio ranging from 0.2% to 0.7%. However, some investment management companies charge an amount which is significantly less than the average cost.

The low expense rate of an index fund can be attributed to the fact that index funds do not require the services of research analysts for the stock-selection process. As the primary purpose of an index fund is to match the performance of the benchmark index, the management of an index fund does not require much effort. Additionally, the companies that manage index funds trade encounter fewer opportunities that require commissions of transaction fees.

On the contrary, the expense ratio of mutual funds is relatively higher. In mutual funds, the expense ratio typically falls in the range of 0.1% to 2.5%. Contrasting the index funds, this price is relatively high. However, as mutual funds have the ability to beat the market index, the cost often is worth the reward.

To understand how expense ratios work, take a look at the following example. Assume that you are an owner of a mutual fund that costs £10 per share, the gross return for it would be 10%. This means, that the total investment return would be £1, per each share. In an ideal scenario, where there is no charge for management, the fund share would be valued at £11 pounds. However, since there is a certain charge, (for example 1%), the amount from the investment would be deducted. As a result, you would make a profit of £0.89, instead of the full £1. Keeping that in mind, your portfolio would be worth £10.89.

Essentially, the cost of the expense ratio comes down to your investment management company. Before selecting a firm to handle your money, carrying out comprehensive research is necessary. Study the firm’s rate of success with its previous investment, and compare the charges with its competitors, although historic results do not guarantee future returns. Based on this research, choose an option that works best for you.

Taking this into account, you can make the decision regarding your investment by considering your budget. If you wish to spend less on investment management and choose a hands-off approach, placing your money in an index fund is the right choice for you. On the other hand, if your goal is to beat the market index, making an investment in mutual funds can work to your advantage.

What suits you?

If you are confused about choosing between index funds and mutual funds, take your investment portfolio into consideration. Before making a decision, set goals for the process. For instance, you need to consider what your objectives for the investment are, and the type of return you desire.

Additionally, if you are not experienced with investing, you are also required to take your stress levels into consideration. For instance, if you struggle with anxiety, choosing an option with reduced risk is recommended.

With mutual funds, you have the ultimate advantage of earning a high return on your investments. However, this comes with a certain degree of risks. While you have the potential to beat the market index, there is no certainty that it will actually happen. Moreover, even if you suffer the losses, you would still be required to make payments to your investment management company.

With that said, mutual funds offer a higher degree of flexibility, which allows you to hedge positions and move assets around, as per your convenience. If you invest in a mutual fund, you are also provided with the opportunity to earn higher returns.

Additionally, if you are looking for a short-term trading option, mutual funds are the way to go. With this type of investment, you can benefit from the short-term gains by carrying out active trade.

On the other hand, if you are looking for a long-term investment opportunity, choosing index funds is the right choice for you. Furthermore, with an index fund, you can also benefit from the reduced cost of investment management.

If you are a first-time investor, an index fund can be the ideal option. This is because, with this type of investment, you are not required to manage or observe the fluctuations in the individual stocks on a daily basis. Hence, index funds offer is more convenient in this regard.

Although, with index funds, you do not have the potential to earn a higher return. Rather, there is a specific benchmark that you cannot exceed. As a result, index funds offer reduced risk.

Ultimately, the decision of what to invest in can come down to your own individual preferences. If you are not afraid of risks, mutual funds can be ideal for you. Although, if you want to go for a safer option, choosing index funds can work to your advantage.

Conclusion

All in all, both index and mutual funds can be ideal investments. Whether you choose to invest in stocks, bonds or other securities, the likelihood of capitalising from the profit is relatively high. The decision to choose your investment comes down to your individual choice. You can either invest in a high-risk, high-reward scenario or play it safe and match the market index. Either way, making an investment mutual or index fund can provide you with a profit.


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