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If you're looking up mutual funds vs index funds, you’re probably familiar with the concept of passive investing and this well-publicized story: In 2007, Warren Buffett of Berkshire Hathaway fame made a $1 million bet against Protégé Partners that hedge funds wouldn't outperform an S&P index fund. Buffett won the bet.
So, index funds beat hedge funds in this scenario, but does that mean that index funds are officially the best investment option? Do they, in fact, reign over mutual funds? If not, what is the best option for passive investors? Let’s take a look.
What are index funds?
An index fund is a type of mutual fund or exchange-traded fund (ETF) constructed to match or track components of a market index. Index funds offer broad market exposure in that they track a benchmark index such as the S&P 500, MSCI EAFE or the Barclays Capital Aggregate Bond Index. (Note: An index fund can very well be made of mutual funds, but what’s different from these compared to managed mutual funds is that they track an index.)
Simply Google the word “index fund” and you’ll see that according to many experts, they’re the darlings of the investment world. Check out our list of index fund pros:
- You’ll get lower expense ratios compared to actively managed funds.
- You buy all the companies in the S&P or whichever index you’re tracking, automatically building in diversification.
- They’re a great option forbuy-and-hold investors for long-term horizons such as retirement investing.
- You don’t need a money manager to help you buy or sell index funds. Instead, you’ll save money because you don’t have a money manager helping you buy or sell your funds.
- You won’t waste money trying to beat the market because you’re a buy-and-hold investor.
- You’re totally diversified, as you own a little bit of everything on the index.
- They’re affordable.
- There could be more volatility in a bear market with an index fund (a good fund manager could have come to the rescue to mitigate some loss in a downturn).
- Massive gains are fairly nonexistent, as investing in index funds is simply a buy-and-hold strategy.
- You have little control over what you’re investing in, just like mutual funds.
What should I know or do before investing in an index fund?
- Are the ones you’re considering commission-free or no-transaction-fee mutual funds or ETFs? Obviously, the fewer costs you’ll need to incur, the better.
- Understand the index. Which one do you want? Of course, the S&P is the most common, but other indexes are also available, and sector-specific indexes are also an option.
- Check investment minimums. How much is the minimum you’ll need to pony up for your initial investment?
- Know as much as you can about the index you’re investing in. If you’re not interested in parsing out the differences between specific indexes, you might consider a total market index.
What are mutual funds?
Actively managed mutual funds are investment funds that pool money from many investors (including individuals, companies and other organizations) to purchase stocks, bonds, and other securities. For the most part, this collective approach offers ample diversification.The pros to a mutual fund include:
- You don’t need to worry about managing your money, rebalancing, etc. on your own. Your fund manager will do that for you.
- They’re fairly liquid, though you’ll need to check with your financial advisor on which type of shares you have (some are “locked up” for a certain length of time).
- Diversification. (This bears repeating because it’s a huge advantage.)
- There are options for you whether you’re okay with risk and or you’re risk-averse.
- Unlike a hedge fund, they’re affordable.
- Fees and expenses are higher, as you’ll pay for a money manager to manage your funds as well as pay the general annual expenses for your mutual fund(s).
- You don’t have control over your portfolio. Mutual fund money managers are the ones who are actually in charge.
- Capital gains are also distributed during the year on some funds or might defer capital gains to later years, creating tax inefficiencies that can deliver a whopping tax bill directly to you.
What should I know or do before investing in a mutual fund?
As with anything you’re investing, there’s a pro list and a con list. It’s true with mutual funds, too, but there are a few other items you should be checking specifically with these types of investments:
- Understand loads and expenses and how those apply to the mutual fund you’re considering.
- Front load: These fees are charged at the time of purchase and can be 5% or more of the amount you’ve invested.
- Back load: These fees are charged on the back end, as the name indicates, or in other words, when you sell a fund.
- No load: These types of mutual funds offer no front or back load; the load fees are waived.
- Expense ratios: While you may or may not be considering a loaded mutual fund, mutual funds do charge expense ratios or have an operational charge. Charges and expenses will vary, depending on which mutual fund you’re considering.
- Is it diversified? Check to see how the mutual fund you’re considering is diversified. Does it offer a combination of stocks and bonds? Typically, most do, as that’s the point of a mutual fund. It might cover a huge bundle of stocks and a few bond funds thrown in for balance. Know what those companies are before you take the plunge; read the prospectus and any other materials you can get your hands on.
- Check out your prospective advisor.Look for your mutual fund advisor in the SEC’s IAPD database, or you can call your state securities regulator or search FINRA's BrokerCheck database.
It may be slightly confusing to try to understand that index funds can be made up of mutual funds, but the nuances lie between the terms “actively managed mutual fund” and “index mutual fund”.
It’s very plausible that an actively managed mutual fund could charge 1.5%, while a comparable mutual fund index fund could charge 0.25%. In answer to our question from the first paragraph, “Are index funds officially the best investment option?” it’s very likely that your actively managed mutual fund will not outperform a run-of-the-mill index fund over time.
Therefore, it’s typically an expensive long-term commitment if you choose a mutual fund over an index fund.However, if you’re not confident in your investing ability, you might carefully consider the benefits of connecting with a financial advisor and investing in mutual funds for the long-term.