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7 Things to Know About Index Funds vs. Mutual Funds

Ellen Chang

The big debate about the value of active management.

Index funds and actively managed mutual funds are among some of the most popular assets that are invested in retirement portfolios. Both of these assets provide diversification and are less risky, allowing people to invest in them with only a small amount of money. "When you're first starting out with investing, you likely don't have a ton of cash to create a diversified portfolio on your own and that's where funds can help," says Rich Messina, senior vice president of investment product management at E-Trade Financial. Here are seven things investors should know about how these two styles of funds vary.

What are index funds?

The goal of index funds is to mirror a benchmark index such as the S&P 500, Nasdaq composite or Russell 2000, decreasing the risk of buying individual stocks. Index funds can be a type of mutual fund, typically cheaper than actively managed mutual funds because the stocks in the fund are not actively managed by a portfolio manager. "Index funds have certainly gained traction over the last decade given the strong performance of the market," Messina says. "As opposed to putting all your eggs in one basket, funds give investors the ability to spread the wealth and get a piece of the pie they wouldn't necessarily be able to get on their own."

Index funds have low fees.

Tracking a benchmark is known as passive investing. This style of investing has grown in popularity for many reasons, especially with the endorsement of Warren Buffet, CEO of Berkshire Hathaway (ticker: BRK.A, BRK.B). Three popular index funds that replicate the S&P 500 index are the Vanguard 500 Index Investor Share Class (VFINX), with an expense ratio of 0.14%; the Fidelity 500 Index Fund (FXAIX), with a 0.01% expense fee and the Schwab S&P 500 Index Fund (SWPPX), with a net expense of 0.02%. While each of these funds mirror the S&P 500, each takes a different approach, says Chris Osmond, chief investment officer at Prime Capital Investment Advisors.

Mutual funds are popular in tax-advantaged accounts.

Mutual funds pool buckets of money for people to invest in stocks, bonds or other assets and offer investors a diversified way to invest broadly across various markets. The distributions and redemptions of mutual funds often trigger capital gains taxes when underlying securities in taxable accounts are sold, "even when there are losses, if long-term gains overshadow short-term losses," says Jodie Gunzberg, chief investment strategist of Graystone Consulting, a Morgan Stanley business. The distributions apply to all shareholders, so timing purchases can matter and selling shares after the distribution generally yields greater gain loss. "However, mutual funds are popular in tax-free accounts like retirement accounts, since no capital gains taxes are generated," she says.

Active investing can be pricier.

Mutual funds are typically known for active investing, since these funds have a manager who trades stocks within a portfolio, says Alex Chalekian, CEO of Lake Avenue Financial. These funds charge a higher management fee than an index fund. The Fidelity Contrafund (FCNTX), one of the largest traditional mutual funds, has a 0.82% expense ratio. The Fidelity 500 Index Fund (FXAIX), which mimics the S&P 500, for instance, carries an expense ratio of 0.02%. Active management may outperform index funds in some situations, but the reverse can also be true. "Keep in mind that just because something is cheaper, doesn't always mean that it's a better investment," he says.

Index funds may suit novice investors.

Investors can invest their money in index funds or active mutual funds or a combination. An index fund could be better for people simply "looking to participate in the market," Messina says. "If you're comfortable with paying more for the potential of outsized gains, an actively managed mutual fund could be the way to go after doing some homework on the track record management style and fees." Since more active managers underperform their benchmark then outperform, be selective when adding actively managed mutual funds, Osmond says. "We mostly utilize managers in inefficient market segments and asset classes like small-cap and international stocks and/or bonds and use more passive or index investments for large U.S. companies," he says.

Active mutual funds can have turnovers.

An investor should be aware of the expense ratio and turnover because these factors directly impact their overall returns, says Stuart Michelson, a finance professor at Stetson University. Funds that have higher turnovers or buying and selling different stocks will seek higher brokerage costs because more trades are made in the mutual fund portfolio, he says. The mutual fund expense ratio reflects all the expenses for managing the portfolio, among other fees. "These are expenses that directly affect and reduce the return to investors," he says. "A mutual fund may have higher total return, but after fees and expenses, the return may be lower than another mutual fund."

Share class can be a factor for active mutual funds.

The share class is a factor to pay close attention to because active mutual funds have various costs that vary with the share class, Osmond says. Institutional share classes are typically the lowest cost share class a mutual fund provider will offer retail investors. The American Century Equity Income Class I (ACIIX) costs 0.72%, for example. The A-shares are typically front-loaded with an upfront sales charge like 5.75% along with 12b-1 fees, an annual marketing fee, or additional fees that are paid directly to an advisor. The A-share class of the American Century Equity Income Fund (TWEAX) charges an initial sales charge of 5.75% and an annual expense of 1.17%.

Know these differences between index and actively managed mutual funds.

-- Index funds have low fees.

-- Mutual funds are popular in tax-advantaged accounts.

-- Active investing can be pricier.

-- Index funds may suit novice investors.

-- Active mutual funds can have turnovers.

-- Share class can be a factor for active mutual funds.

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