You probably know that one of the most important aspects of successful investing is a healthy diversity in your portfolio. One of the ways that many people attempt to add diversity to their portfolios is by investing in funds. Funds offer a collection of investments. You invest in the fund, and you automatically invest in everything that is in that fund. For many — especially inexperienced investors interested in buy and hold — funds offer instant diversity.
Two common types of funds are mutual funds and index funds. While an index fund is actually a type of mutual fund, many people see them as two separate investing options. As a result, it makes sense to treat them as such, especially since there are some differences that are important when you consider actively managed mutual funds vs. index funds.
Actively Managed Mutual Funds
Mutual funds can be invested in stocks, bonds or other assets. They are often divided into two broad categories: growth and income. Growth funds are supposed to provide you with significant growth, and often include aggressive investments with the possibility of high returns. Income funds are meant to help you earn a steady income. These are often invested in bonds and dividend paying stocks. It is possible for people with income funds choose to have the income automatically reinvested.
The main trait of actively managed mutual funds is that they are overseen by a professional fund manager. This fund manager chooses which investments are held in the fund, according to what he or she thinks will best suit the goals of the fund. With professionally managed funds, there are often higher fees, since someone has to make decisions about what is in the fund. Sometimes these fees can be higher than 2%, cutting into your returns.
Another issue with actively managed funds is turnover. A transaction fee may be charged each time an investment is switched out or added. Higher turnover in some actively managed mutual funds can lead to even more fees, and also to tax obligations, since earnings may be realized as investments are changed out.
As mentioned above, index funds are a type of mutual fund. However, they operate a little differently. You are still end up with shares in many different investments at once, but the performance of the fund overall tracks a particular index. There are indexes that follow stocks, bonds and other assets, and there are indexes made up of certain types of investments, such as alternative energy stocks, or a collection of emerging market bonds.
As with actively managed mutual funds, you can choose whether you want your investments geared toward the possibility of higher returns with aggressive growth indexes, or if you are more interested in slower growth and less risk. However, you have to make your own decisions about what to invest in, and then let the index do its work, since the investments in the fund track the index, rather than being individually chosen by a professional.
Because of this simple method of building a fund, index funds are often cheaper than actively managed funds. Turnover is lower, and annual fund fees are usually in the 0.5% to 0.75% (although, of course, the fees can always be higher).
Something to Consider about Funds
With any fund, it is important to remember that investments can result in a loss — no matter how low-risk they are considered to be. Many index fund proponents point out that, historically, stocks have never lost in any given 20-year period of time. The idea is that if you invest in an all-market index fund, you should win out over the long haul. Analysis of other investments tend to show something similar: Overall, fund investments win out if you hold them long enough, even though they have varying returns and success.
It is important to note, though, that there is a first time for everything, and that an eventual recovery in 10 years seems hollow to someone whose portfolio tanks just before retirement. You always have to be aware of the risk of loss, and the possibility that your portfolio could sustain a severe blow just prior to your needing it. This is one of the reasons diversity is so important.
In the end, what you choose depends on your end goals, and what type of fund you think is most likely to help you reach your financial goals. You can consult an investment professional or financial planner to help you figure out whether mutual funds or index funds might be most helpful.