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What are the benefits of investing in a fund? What is the difference between index vs. mutual funds?
Both index funds and mutual funds allow you to invest in a diverse group of investments. The main difference is that index funds invest in a specific group of assets (e.g. S&P 500 stocks), while mutual funds invest a changing list of assets, selected by a fund manager.
In this article, we’ll explain the difference between index funds and mutual funds: how they work, their benefits, and their disadvantages.
What Is a Fund?
A “fund” is a diverse group of investments. When you buy into a fund, you’re actually buying a variety of stocks and bonds, without the hassle of choosing each of them individually. So, what is the difference between index vs. mutual funds?
Active Management: Mutual Funds
A mutual fund is a collection of different investments. Mutual fund managers buy each of those specific investments (using a pool of money contributed by a group of individual investors) depending on what they think will generate the best returns. We call this “active management” because an actual human is in charge of picking and choosing where to invest the fund’s money.
The benefit of a mutual fund is that each person who buys into it is automatically investing a little bit of money in each of the stocks and bonds that make up the fund. In other words, as an investor, you get all the benefits of a diverse investment portfolio without having to worry about picking specific stocks yourself. Mutual funds also sometimes produce amazing returns, but that performance only lasts a year or two.
However, actively managed mutual funds have a major downside: fees. We already know that mutual fund managers typically can’t beat the average market returns—so if you invest in a mutual fund, not only will you likely see subpar returns, but you’ll pay significant fees that sap the value of your investment even further. These fees (or “expense ratios”) are usually 1-2% of assets managed per year. That may not sound like a lot, but those fees compound—which means a 1% fee can end up reducing your overall returns by a whopping 30% in the long run.
Passive Management: Index Funds
Thankfully, you can bypass those fees by investing in index funds. Index funds are “passively managed” because they don’t have a fund manager who chooses which stocks and bonds to invest in. Instead, they use a computer algorithm to automatically invest in all the stocks in a given index, which is a section of the stock market (for example, NASDAQ is an index of technology stocks). This means that the value of an index fund will rise and fall in the same pattern as the section of the market that the index represents.
In the short term, index funds might not always match the returns of mutual funds because they track so closely with the wider market. However, in the long run, passively managed funds are a far better deal because there is no fund manager’s salary to pay, so the fees are much lower. For example, an index fund might have an expense ratio of 0.14% compared to a mutual fund’s 2% expense ratio.To understand how important those low fees are, let’s look at an example. If you invest $100 per month in a mutual fund with a 1% expense ratio and keep that making that monthly investment for 25 years, you’ll pay almost $12,000 more in fees than if you’d invested that same money in an index fund with a 0.14% expense ratio (assuming the standard 8% return). The more money you invest, the more money you lose to mutual fund fees. For example, if you initially invested $5,000 in that same mutual fund and contributed another $1,000 each month after that, after 25 years, you’d pay $126,418 more in fees than you would for an index fund.
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- The small steps you can take towards living a "rich life"
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