For those of us not interested in picking individual stocks, funds are a great solution. Someone else chooses exactly how to invest the fund, and all you have to do is buy one product. Two popular types of funds are actively managed mutual funds and index funds. Today, we’ll look into the similarities and differences between them.
Investment Strategy
The core difference between an index fund and an actively managed mutual fund is the investment strategy. A mutual fund manager actively selects investments in the hope of beating the market. But in an index fund, the goal is only to match a specific indicator. So, for instance, an index fund based on the S&P 500 tracks its gains and losses as closely as possible.
Why would anybody choose to track the market instead of beat it? Simply because it is much easier to do. It doesn’t require any active management at all, because the fund in our example owns shares in each of the companies listed in the S&P 500. If a company falls off the S&P 500, the fund sells shares in that company and buys shares in its replacement. This way, it easily tracks the chosen indicator without active effort.
Beating the market is much harder to do. Barely 10% of actively managed mutual funds beat the market each year. Succeeding requires being able to guess ahead of time which stocks are undervalued and which might be due to crash. However, in bear years, sometimes key indicators crash while actively managed funds do better. Seeing storm clouds on the horizon, the fund manager moves investments into more stable products. But if they don’t predict the market correctly, they may underperform it instead.
Costs
Whenever you invest with a brokerage, whether you’re buying a mutual fund or an index fund, you’ll pay fees. However, the fees for an index fund are much lower. This is because they don’t need to have an expert actively picking stocks for you. In a mutual fund, you’ll pay a higher rate because of the extra service you receive—an expert fund manager picking stocks and trying to outperform the market. This person may not outperform the market most years, but they may be able to cushion you from a blow in years where key indicators decline.
Fees on mutual funds are calculated as an expense ratio. For instance, a 1% expense ratio would mean you spent $1 for every $100 you invest in the fund. Index funds average about 0.06% in fees, while actively managed mutual funds average 0.68%. That’s ten times as much! So index fees will cut into your gains much less.
Taxes
There is one further consideration between the two types of funds: taxes. The frequent buying and selling required by an actively managed mutual fund result in many taxable events throughout the year. You’ll likely end up paying more in taxes than you would with an index fund.
The exception is when your mutual fund includes tax management. By carefully offsetting gains with losses and holding stocks for a longer period of time, the fund can avoid making you liable for as much capital gains tax.
Mutual Fund or Index Fund?
For most investors, an index fund will be the smarter option. It doesn’t promise as much, but it reliably delivers gains to equal its indicator. With lower fees, it’s also the economical choice. However, some investors may prefer an actively-managed fund in the hopes of achieving higher gains. For help with this decision, speak to your financial advisor. You can meet an expert advisor for your needs when you contact us.
