September 28, 2020
By Rahul Iyer
In contributing to a retirement plan, your financial advisor will present mutual funds and index funds as options. Before you decide, you need to get an understanding of what these funds are and how they differ from each other. This article will give you the basic information you need to decide between the two.
A mutual fund is a pool of money from several investors that is used to invest in different securities such as stocks and bonds. A mutual fund is usually actively managed by fund managers who select investments. This fund manager is paid by the fees of shareholders.
Mutual funds have a low level of risk when compared to directly investing in stocks and bonds. The shares that are available to the investors of this fund are called mutual fund units. These are typically sold to investors at the net asset value (NAV/NAVPS) per share. This value is calculated by dividing the total value of all the securities in the fund by the number of outstanding mutual fund units.
Index funds are somewhat related to mutual funds. They are designed to mirror key benchmark indexes such as the S&P 500 or the Russell 2000. This type of fund includes stocks, bonds, and other investment vehicles. Index funds are designed to be passive while tracking an underlying index.
Index funds invest in the same investment options as the index that it seeks to mirror. Therefore, if you are investing in an index fund that mirrors the S&P 500, its portfolio includes stocks such as CVS Corp., Facebook, Goldman Sachs, or Ford Motor Company. Because the fund invests just like the index it is following, you will notice a similar movement in the percentage as the index that the fund is copying.
The three areas in which the two funds differ are management style, goals, and cost.
Management style: This has to do with whether the fund is passive or active. The management style of index funds is passive; therefore, therefore the manager of the fund is not actively adding or selling investments. Mutual funds, on the other hands, are actively managed. The management of a mutual fund will select individual stocks, bonds, or other securities.
Goals: An index fund is designed to match the returns of the underlying index; on the other hand, a mutual fund aims to outdo the return of a related benchmark index.
Cost: A mutual fund will cost you more in fees than an index fund. The average fees involved in investing in a mutual fund range from 1% to more than 3%. The typical fees for index funds range from as low as 0.05% to 0.07%. There are some index funds that will charge higher fees than mentioned here.
In selecting which of the two to invest in, you must consider your goals. Mutual funds usually feature more flexibility in moving assets around, offers higher potential returns and gives you an opportunity to benefit from short-term capital games. Index funds have lower fees, gives you access to stocks of huge companies, and you can leave your funds in an index fund and forget about it. Both have its pros and cons.
Which will you choose?