Whilst practically everybody knows about mutual funds, with the stats showing that more than half of American adults have money invested in such a fund, much less is know amongst the general public about index funds. This is not a good thing! Everyone needs to know about all the investment options available to them. Many people, for instance, have the option to choose between the two as part of the employer’s retirement plan.
So, if you are one of the many who does not have the knowledge to distinguish between the two, you are in the right place! Read on..I will explain everything you need to know about the Index Funds Vs Mutual Funds debate!
Index funds are effectively clones of stock market indices. These indices measure the total value of a stock group. The S&P 500 is one of the most popular indexes. This consists of 500 large cap stocks which are selected to reflect the market average. There are many other indexes too, such as the Russell 2000.
The very first index fund appeared back in 1975. The creator was the John Bogle, who was also the founder of Vanguard. Nowadays Vanguard are strong proponents of index fund investing, and this is the company which has now become the second biggest mutual fund holder in the world.
Index funds are a specific type of mutual fund, and they are meant to reflect the stock market index performance. In the same way as a mutual fund, the share values of index funds are determined according to the value of all the stocks the fund has bought into.
Unlike mutual funds, index funds are not bought and sold via managed trades on a regular basis. Index funds use a set of rules to change the investments, and this occurs infrequently. This takes the human element out of the process.
Index funds consistently outperform mutual funds for the following 3 reasons:
1 – They have much lower management fees. Mutual funds are actively managed, and hence the large fees on them.
2 – They trade infrequently so the turnover ratio is a lot lower. This can have a positive impact on capital gains tax liability.
3 – Many mutual funds have the goal to just meet the market indexes, and no more. Only 15% of them actually beat the market average.
Here is an example real comparison between the two. My colleague was given the two options for his company retirement plan:
Index fund: The Vanguard international stock index has beaten the international stock index in all but one of the last 5 years. The expense ratio is just 0.26%
Mutual fund: The Artisan international has beaten the market in just 2 of the last 5 years, and has an expense ratio of 1.2%.
There are an increasing number of knowledgeable investors who put their money only into index funds as they believe that they are superior in every way to mutual funds. In the majority of cases, they are right. This does not mean that this is a fool proof rule though; of-course there are exceptions, and as ever you need to do your research! If you have the option of a particular mutual fund or a particular index fund, then, despite what you have read in this article, make sure you study them both.
For more information, go to:
en.wikipedia.org/wiki/Mutual_fund,
en.wikipedia.org/wiki/Index_fund
