This post may contain affiliate links. Please read my disclosure for more info.
If you’re just starting to invest, then you may or may not have heard of the terms mutual funds and index funds. Well after reading this post, you’ll have a good idea on what those two are and be able to make a solid choice if you are interested in investing in them.
Both mutual funds and index funds take in your money and put it into investments such as stocks, bonds and other assets. Making your portfolio much more diversified. A big confusion in investing talk is the relationship between mutual and index funds. To put it simply, index funds are a type of mutual funds, but not vice versa. Typically, when someone refers to the term mutual fund, they are most likely referring to an actively managed mutual fund.
The objective of mutual funds is to attempt to beat the market or an index, for instance, the S&P 500 index. However, the objective of index funds is to simply match the returns of a particular index, again like the Standard & Poor’s 500.
All this will become more clear after we compare both investment options. Let’s start with the mutual funds.
Let’s take a closer look into mutual funds. We know that the selling point for mutual funds, is that it attempts to perform better than the market. But, we will see how these funds are managed and what type of fees are associated with them.
When compared to index funds, mutual funds are actively managed. This means that someone, usually a fund manager or a management team, is constantly trading stocks (buying and selling) in an attempt to beat the market. They move around to look at stocks in different indexes and in various investment types because they hold control of all the investment decisions.
Their main goal is to try to beat the index they are competing against. However, based on history, it is extremely difficult to outperform the market indexes. And even more shocking is that most mutual funds DO NOT perform better than the indexes.
To invest in mutual funds, you have to pay some fees. Why? Because they are attempting to beat the market and yield higher results. And by they, I mean the fund managers. That means that this is their job and where does their pay come from? Bingo, your fees! These people have to get paid for actively managing your mutual fund investments, not to mention the cost of office space, bonuses and other miscellaneous costs.
The management fee, or expense ratio differs for each mutual fund, but on average it could range from 0.8% t0 2% and sometimes even more. In addition, there could be even more hidden fees depending on what type of mutual fund you get, where you make your investment and such.
There’s also a required minimum investment amount most of the time when you decide to invest in mutual funds.
So if you were to invest in actively managed mutual funds and even if it did better than the index it was competing against, you could still end up losing money. Due to all the fees associated with mutual funds, and therefore making your investment actually underperform overall.
Now you know what mutual funds are in more detail, it’ll be easier to understand index funds as well. Remember, the objective of index funds is to simply replicate the market indexes that a particular index fund might be tracking. Not to beat it. Let’s take a closer look at them so you can clearly see how they are managed, who manages them, and the fees associated from investing in them.
Index funds are passively managed. This just means that no one in particular is watching and trading the stocks or investments in the fund. It’s all automated to match an index. For instance, if a certain index fund is tracking the S&P 500 index, it will have all the stocks that are in that S&P 500 index.
Therefore, the performance will exactly mirror the index that the fund is tracking. So, if the S&P 500 tanks and then spikes and does a rollercoaster move, the associated S&P 500 index fund will do the same as well. Because again, the index fund aims to simply match a market index, not try to outperform it.
There are fees when investing in index funds, but since there are no fund managers involved in index funds, the fees, as you would guess, are significantly LOWER when you compare them to mutual funds. Because it’s all done by computers!
On average the expense ratio for index funds is usually below 1%. If you look around you can find relatively cheap index funds to invest in.
In comparison, index funds are not managed by any fund managers or management team, but instead by computers, making them passive. And the fees are much less than mutual funds. So you can probably guess at this point which investment is better.
Which Is A Better Investment?
The clear winner here is index funds!
While they don’t try to beat the market or an index they’re tracking, it actually works out better than an actively managed mutual fund. This is because the fees you pay to invest in index funds are much lower than mutual funds. And most of the time, mutual funds don’t outperform the market. And even when they do, you still may not have gained much if any due to the fees you’ll have to pay. Therefore, for shareholders, the returns will generally be higher the less management fees there are.
Overall, if we’re comparing mutual funds and index funds, index funds are better. For most people, this will work out fine. BUT, if you want to yield higher gains and actually outperform the market, there is a better option.
Individual stocks! Investing in individual stocks can be better, if you’re willing to put in the work and do your research. You get out what you put in. Because, let’s face it, NO ONE is going to care for your money the way you will care for it. You can actually beat the market if you do your homework. Now, I’m not saying you will always see gains because everyone will make mistakes and have some failures. But, if you’re willing, you can do it!
Related Post: How to Start Investing
If you’re not about investing, and you just want to sit back, invest and forget about it, then index funds are the way to go!
I hope you enjoyed this post and found it useful. Feel free to leave a comment if you have any questions or anything, I’ll be glad to address them! Also if you enjoyed reading this, then consider subscribing to Parhelia Finance’s email list below and sharing it on social media!