In a previous blog post, we spoke about what retirement accounts to invest in. You can check out that blog here. But what if you want to invest in an account that isn’t meant for retirement? Two popular ways of investing in the stock market is to invest in either index funds or mutual funds. Investing in either is made possible through virtually any bank. Simply open an investment account online, and connect with a customer support agent to help you with the process. But what exactly are index funds or mutual funds? What’s the difference between the two? Which one is better?
Index Funds
An index fund is a portfolio of stocks designed to mirror the performance of a particular market. The S&P 500 index fund, for example, is a pool of the 500 largest publicly traded companies in the U.S. If you invest in the S&P 500 index fund, you will own a stake in all of these companies, which make up 80% of U.S. stocks! The benefit of this index fund is that if one or a few of these companies underperforms financially, it won’t negatively impact the index fund too much due to all the other companies keeping the fund up. You can invest in an index fund just as you would any stock, by purchasing a share through your investment account.
Here are some of the benefits and drawbacks of index funds:
Benefits of index funds:
- Passive investment- Instead of actively selecting stocks, index fund allows for a “set it and forget it” approach
- Low fees- Because index funds aren’t managed by a fund manager, fees/expenses associated with transactions are really low
- Investment diversification- There can be thousands of different stocks held in a single index fund, each company stock different from the other. This means no one stock within the fund can bring the whole fund down. This lowers overall investment risk
- Historical outperformance- The stock market has recovered from downturns 100% of the time. Over the long term, index funds have generally outperformed any individual stock
Drawbacks index funds:
- Limited flexibility- Index funds are rigid in their investment strategy. If you purchase a real estate index fund, for example, the index fund won’t include other asset classes if there is a downturn in the real estate market
- Automatic inclusion- By design, index funds match market returns by including the majority of stocks within a particular market (e.g., technology sector). This means the fund will never outperform the market. When there is a market downturn, an index fund can only do so well. Opposedly, there are some individual stocks that historically outperform the market during economic downturns (e.g., food/beverage companies, essential household products, etc.). This is because these business models are less impacted by economic fluctuations.
Mutual Funds
Rather than investing in a traditional index fund, you have the option to invest in a mutual fund. All mutual funds are index funds, but not all index funds are mutual funds. A mutual fund pools money from many investors to buy a variety of stocks, bonds, or other securities that create a diversified portfolio of assets.
The major difference between mutual funds and index funds is that mutual funds are managed by a fund manager, who guides the fund’s objectives and adapts to market conditions over time. The fund manager decides what sort of investments the mutual fund will make according to what the objective of the fund is.
Typically, mutual funds are categorized as growth, income, or balanced. Growth mutual funds are invested aggressively in new market trends (e.g., A.I companies). They are called growth funds because picking the right new market trend can lead to exponential growth. The problem here is that new trends come and go, and if you pick the wrong market trend you can be left with tremendous losses. Another type of mutual fund is known as income funds. Income funds, also known as large-cap funds, are funds that invest in household brands that are consistently promising (e.g., costco). There isn’t a lot of growth in these markets, but there is also not a lot of down swings in these reliable businesses.
Balanced funds have a mixture of both growth funds and income funds. This allows for investing in new market trends while also having a stable foundation to your portfolio with income funds. The fund manager manages these funds for you by investing and selling stocks within that fund to best align with the funds objectives of growth, income, or balance depending on market conditions and changing environments.
Here are some benefits and drawbacks of mutual funds:
Benefits of mutual funds:
- Professionally managed- Experts actively manage your money, so you don’t have to. Their job is to think about their clients money all the time, which allows them to research/analyze the best strategy for investing your money
- Flexible investment strategy- A mutual fund manager can adapt investment strategy according to market conditions. A balanced mutual fund, for example, will reallocate money to different stocks/bonds to take advantage of cheap prices, or stay away from stocks that are prone to the next market downturn.
- Investment diversification- Just like an index fund, mutual funds are also a portfolio of a wide range of stocks. This allows you to not have all your eggs in one basket when investing.
Drawbacks of mutual funds:
- High/hidden fees- Mutual funds are known for having extremely high fees. This is because you are essentially paying someone to manage your money! These fees cover the fund’s operational expenses, sales charges, as well as salaries of professional managers. Know what fees are included in your mutual fund before purchasing.
- Lack of control- Though mutual funds are actively trading/buying stocks, you have no say in what the fund is investing in. Sure, you have an idea of the market and strategy of the fund you purchased, but that can change at any moment depending on market conditions. You have no say in what stocks get sold or bought within the fund
- Non-fiduciary duty- Some mutual funds have a fiduciary duty, while others don’t. A fiduciary duty means the fund managers make a percentage of what the clients make in the fund. This incentivizes the fund managers to pick the best investment strategy for their clients. Non-fiduciary funds make the majority of their money through other fees, which are charged regardless of if the fund increases in value. In other words, with a non-fiduciary fund, the fund managers don’t have an incentive to pick the best investment strategy for their clients. Do your own research before purchasing a specific mutual fund to understand the fee structure and costs associated
To learn how to select the right mutual fund, I highly recommend checking out this blog by Dave Ramsey.
Conclusion
To conclude, all mutual funds are index funds, but not all index funds are mutual funds. An index fund allows for passive investing with low fees and diversification, while mutual funds offer professionally managed portfolios with a flexible investment strategy.
Both have their own pros and cons, and I hope you have the information necessary to make your own decision on which one to invest in, if not both.
Personally, I am currently not invested in mutual funds. This is mostly because I can’t justify the high fees associated. Some people argue that the high fees steal too much from your potential returns. For this reason, traditional index funds generally outperform mutual funds. The only reason I would ever consider investing in a mutual fund is if I was interested in investing in a specific market, but simply had no time to do the market research myself. I can read the prospectus of a few mutual funds invested in that market. A mutual fund’s prospectus provides information about the fund’s investment strategy, objectives, risks, fees, historical performance, and more. Now, I can make an educated decision on which fund to invest in based on expert research, rather than researching everything on my own.
That being said, I would never recommend investing in something you don’t understand. Understand the mutual fund’s prospectus before investing, and ask questions if needed!
At this point in my blog posts, I have mentioned stocks, bonds, mutual funds, and index funds. And it has occurred to me that I haven’t necessarily provided a concise blog on the different asset classes, along with their differences. Follow along the next blog to learn more about different asset classes.