The Differences between Index Funds and Managed Mutual Funds

There are many different types of mutual funds you can invest in. Two of the broadest categories for mutual funds are index funds and actively managed funds. The differences between index funds and managed funds are quite important to how the fund works. But what are the key differences between these two types of funds?

By far the easiest way to invest in a fund is to pick a common stock index, such as the S&P500, and find a fund that tracks that index. These funds generally have low fees, as they don’t need to spend a lot of money to managers that are highly paid and spend lots of time (and money) researching new investments. Index funds are passively managed, meaning that the fund managers don’t make investment decisions themselves, rather they rely on the index to decide what the fund owns.

An index fund does not try to outperform another index. Actively managed funds often compare their performance to indexes. In contrast, and index fund attempts to match the performance of those indexes, it does not try to outperform them.

Actively managed mutual funds have managers who try to select what they hope will turn out to be stocks that perform well. These managers are professional stock pickers. They research potential companies and make all of the decisions about how the money in the mutual fund is invested. A good manager can make a mutual fund highly successful, and a bad manager can kill a fund. Because a manager is so important to the success of a managed mutual fund, many private investors (more experienced ones) pick funds based on who the manager is and what that person’s personal history for making money is.

At first glance it may appear that an actively managed fund may be a better choice. Isn’t it always better to have a professional making decisions? Interestingly, index funds often outperform activity managed funds. Very few active managers consistently beat the passive indexes. Because of this, index funds are often very good investments.

Index funds have the advantage of low expenses and low taxes. When index funds were first introduced the investing public, they were branded as “unpatriotic” and “amateurish”. Of course, they were called this by active fund managers who saw their jobs at risk, so take the criticism with a grain of salt.In the beginning only large institutions could buy index funds. However, in 1975 John Bogle started offering S&P500 index funds to individuals. He went on to found Vanguard, which is now one of the largest mutual fund companies that specializes in index funds. Today, the Vanguard S&P500 index fund is one of the largest and most famous of all index funds on the market.Index funds are inexpesive to run compared to actively managed funds. All the workd and decision making is done with a computer program. There is often very little buying or selling as the indexes don’t change very often. The index funds that track the S&P500 can have an expense ratio of one fifth of one percent – a very low expense rate by any measure. If you are holding this investment for many years in hopes of using the money for retirement, the lower expenses can put a lot of extra money in your pocket over the years.The differences between index funds and managed mutual funds is really quite simple. Index funds are passively operated, with no active manager making investment decisions. Actively managed funds have a professional who picks what stocks and bonds the mutual fund will own. Index funds can be cheaper to run, and they often beat the actively managed funds. However, a well run fund, operated by someone who really knows stocks, can beat index funds – with greater risk of course.