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Understanding the Difference between Mutual and Index Funds

One of the most important aspects of investing successfully is a diversified portfolio.  In doing so, you spread out your investments in a much healthier span in order to minimize risk and increase returns.

One of the ways many people choose to diversify their portfolios is to invest in funds. Funds are not just one investment, but a collection of investments.

When you invest in a fund, you invest in everything within that specific fund.  As you can see, funds offer instant diversity, which is why it’s easy to understand how popular they are.  However, understanding the different types of funds available for you to invest in is the tricky part.

Two of the most popular types of funds are mutual and index funds.  Granted, index funds are actually a type of mutual fund, but they have such different attributes and investment factors that most view them as two separate investment options.  Let’s delve into the main differences between mutual and index funds, and try to setup a framework for you to understand which option is best for you.

Mutual funds are actively managed funds that can be invested in stocks, bonds or other assets, and are often divided into two broad categories: growth and income.  Income funds are focused on helping you earn a steady income, and are often invested in bonds and dividend paying stocks.  Growth funds are focused on helping you earn significant growth, and often include aggressive investments with the possibility of high returns.

The main characteristic of mutual funds is that they are actively managed by a professional fund manager.  The fund manager decides which investments are included in the fund according to the goals of the client.  Negative factors associated with mutual funds include higher fees, sometimes more than 2%, because of the active decision making of the fund manager, which can definitely cut into your return.  Additionally, higher turnover from switching investments leads to transaction fees and tax obligations.  Mutual funds put most, if not all of the power in the hands of the professional fund manager, thus leading to costly losses if you choose an incompetent fund manager.

Index funds, while still under the category of mutual funds, operate a little differently.  Just like mutual funds, index funds offer great diversification, but instead of being actively managed by a professional fund manager, the shares track a particular index.  There are indexes that follow stocks, bonds and other assets, and there are indexes made up of certain types of investments.  Also like mutual funds, index funds can be geared towards growth funds or income funds.

However, you must make your own decisions about what to invest in, and then let the index do its work, since the investments in the fund track the index, rather than being individually chosen by a professional.  Index funds cheaper than actively managed mutual funds and they yield a lower turnover rate.  Proponents of index funds believe that they consistently outperform their actively managed mutual fund peers due to these reasons, but it bears repeating that in order for this to happen you must have enough financial savvy to determine the right investments to participate in.

It is important to note that each client’s goals are different, resulting in a much differently prepared portfolio.  Regardless of which method is right for you, remember how important diversification is to your financial future while investing.  Do your research and get in touch with your financial professional to determine which type of fund is best for you.