Ready to start investing? Maybe you have a choice to invest in funds through your 401(k), or you’re just getting started with a Roth or traditional IRA. Here’s what you need to know about choosing whether to invest in index funds or actively managed mutual funds.
Index funds are a type of mutual fund. Index funds include a broad-based selection of publicly traded stocks shares based on a particular companies. For example, the first index fund included shares in all the funds on the S&P 500. Other funds are indices of companies based on sector (Health Care, Information Technology, Emerging Markets) or attribute (dividend payment, market capitalization).
Index funds are relatively new; they were first introduced in 1976 by John Bogle, the founder of Vanguard. Before index funds came along, most investors who wanted to invest in several companies at once, bought shares in an actively managed mutual funds.
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By their very nature, index funds will not outperform the market.
Stocks held in actively managed mutual funds are selected by fund managers. Fund managers perform predictive analyses on companies and buy or sell based on market conditions, company performance, or other criteria.
Fund managers may invest in new and promising companies in order to boost the performance of their fund. Generally, the goal of actively managed funds is to provide investors with a return that is higher than the market’s average.
Both mutual funds and index funds provide a simplified option for individual and institutional investors who would like to invest in stocks but would prefer to diversify their exposure.
The primary difference in mutual funds and index funds is found in the expense ratios. Index funds tend to have lower expense ratios for two reasons. One, they don’t need to pay salaries to active fund managers. Once the criteria for funds are set, much of the subjective human element is eliminated from the choosing of funds. Two, fewer trades means less capital gains tax, which results in a lower fund cost.
What do you prefer investing in? Index funds or actively managed mutual funds? Let us know in the comments.