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April 3, 2024

Investment Essentials: What is the Difference Between Index and Mutual Funds?

When you are trying to find the best investment options for your hard-earned money it can be very confusing to be presented with so many choices and lots of terminologies that you might not understand properly.

Sites such as mywealthandinvestment are designed to try and help steer you through that minefield with helpful suggestions and pointers, and they may well talk about index and mutual funds.

The question is do you know the difference between the two?

Here is a guide to the key differences between these two different types of funds that you need to be aware of when deciding how and where to invest your money.

A fixed list of investments or a changing portfolio

In vest basic terms, the fundamental difference between an index fund and a mutual fund is the fact that if you invest in an index fund you will be exposing your cash to a specific set of securities. 

An index fund consists of a specific set of stocks that make up a particular index, the S&P 500, or the FTSE 100, for example. Indexes are a barometer that indicates the health of the markets and the main companies within that particular market. 

That means that an index fund is designed to deliver what you would call market-average returns.

In contrast, a mutual fund employs an investment fund manager who is tasked with creating a changing portfolio that is always trying to outperform the market.

In theory, a mutual fund has the capacity to outperform an index fund over time. This is because the index fund is more aimed at delivering average returns.

Risk and reward

Very little is guaranteed when it comes to stock market investing and if you are seeking a more predictable performance rather than seeing the value of your investments fluctuate more regularly, an index fund, in theory, should be the less volatile option.

The key objective of an index fund is to mirror the investment returns of a benchmark stock market. If the blue-chip companies within that index are performing well you should find that your index fund rises in value in line with that growth.

In contrast, you are relying on a particular fund manager to use their expertise to spot opportunities and invest in a basket of different stocks that they believe will outperform the index, collectively.

The key point to bear in mind about an index fund is that it is a passive management style that is more about following a fixed portfolio of stocks within the chosen benchmark index.

What you are paying for when you invest in a mutual fund is a manager who is running an active fund that has the freedom to choose and change fund holdings to try and get the best returns.

Some investors are of the opinion that passive investing via an index fund will deliver more consistent returns every year and that is the way to make money in the longer term. However, so fund managers have developed an enviable reputation for delivering exceptional returns with their stock-picking skills.

It is a personal choice. As long as you know the reason why you are investing in an index or mutual fund, you can decide for yourself which one suits your investment style and goals.

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