When you look at recent history, actively managed funds have performed poorly compared to index funds. According to Morningstar, two-thirds of large-cap growth stock mutual funds underperformed the index, and nearly three-quarters of large-cap blended funds failed to match their benchmark. The same was true in 2014, when 86% of active large-cap fund managers fell short of their benchmarks.
In this article we look at (almost) if not everything about an index fund and mutual funds.
Hint to what we cover in this post;
•What is an index fund
•How an index fund works
•Type of index fund
•Why you should invest in an index fund
•Advantages and disadvantages of an index fund
•Statistical example of an index fund in real-world
•What is a mutual fund
•How a mutual fund work
•Type of mutual fund
•Advantages and disadvantages of a mutual fund
•Statistical examples of a mutual fund to real-world
Then we will move further to this discuss the differences between index funds and mutual funds.
So don’t leave this page in a hurry!!!
Now, let’s start the discussion
What is an index funds?
An index fund is a mutual fund or ETF whose portfolio is designed to replicate a certain market index.such as the Standard & Poor’s 500 Index (S&P 500).
Index funds are generally considered ideal core portfolio holdings for retirement accounts, such as individual retirement accounts (IRAs) and 401(k) accounts. Legendary investor Warren Buffett has recommended index funds as a haven for savings for the sunset years of life. Rather than picking out individual stocks for investment, he has said, it makes more sense for the average investor to buy all of the S&P 500 companies at the low cost an index fund offers.
An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover. These funds follow their benchmark index no matter the state of the markets.
How an index funds works
An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index.The idea is that by mimicking the profile of the index—the stock market as a whole, or a broad segment of it—the fund will match its performance as well.
There is an index, and an index fund, for nearly every financial market in existence. In the U.S, the most popular index funds track the S&P 500. But several other indexes are widely used as well, including:
the Dow Jones Industrial Average (DJIA) consisting of 30 large-cap companies
the Wilshire 5000 Total Market Index that is the largest U.S. equities index
the MSCI EAFE consisting of foreign stocks from Europe, Australasia, and the Far East
the Barclays Capital U.S. Aggregate Bond Index following the total bond market.
For example, the popular Dow Jones Industrial Average (DJIA) is an index that consists of 30 large U.S. stocks, weighted by share price. So an index fund that tracks the DJIA would be expected to own all 30 stocks in approximately the same proportions that they make up in the index.
Types of index funds
there are different tyes of stock index funds which includes;
1.Broad market index funds: These invest in an index designed to track the performance of the entire market, or a subset of the market such as large-cap stocks. The Dow Jones Industrial Average, S&P 500, and Russell 2000 indices, are examples.
2.Global/International index funds:These are designed to provide exposure to stocks all over the world. Global indices include stocks from all over the world, while international indices exclude U.S.-based companies.
Sector-specific index funds : These are designed to track a sector’s performance. For example, the Financial Select Sector SPDR ETF (NYSEMKT: XLF) is designed to mirror the performance of the banking, insurance, and real-estate industries.
Why invest in index funds?
Index funds have become quite popular, and for good reason. First, because index funds don’t require much effort from managers, they typically have lower fees than actively managed funds. It’s not uncommon to find index funds with expense ratios in the 0.05%-0.07% range, while actively managed funds are generally in the 1%-2% ballpark.
Additionally, index funds allow investors to harness the long-term potential of the stock market without the guesswork and research involved with choosing individual stocks. In fact, there are many economists who believe in the efficient market hypothesis — which says that it’s not possible to beat the market consistently, so the best way to invest is to simply buy all stocks. An index fund allows investors to do that.
Advantages of index funds:
One primary advantage that index funds possess over their actively managed counterparts is the lower management expense ratio. A fund’s expense ratio—also known as the management expense ratio—includes all of the operating expenses such as the payment to advisors and managers, transaction fees, taxes, and accounting fees.
Since the index fund managers are simply replicating the performance of a benchmark index, they do not need the services of research analysts and others that assist in the stock-selection process. Managers of index funds trade holdings less often incurring fewer transaction fees and commissions. In contrast, actively managed funds have bigger staffs and conduct more transactions, driving up the cost of doing business.
The extra costs of fund management are reflected in the fund’s expense ratio and get passed on to shareholders. As a result, cheap index funds often cost less than a percent—0.2%-0.5% is typical—compared to the much higher fees actively managed funds command—typically 1% to 2.5%.
Other pros are;
• Ultimate in diversification
• Low expense ratios
• Strong longterm returns
• Ideal for passive, buy-and-hold investors.
Disadvantages of index funds
• Vulnerable to market swings, crashes
• Lack of flexibility
• Limited gains
Statistical example of an index fund in real world
Index funds have been around since the 1970s. The popularity of passive investing, the appeal of low fees, and a long-running bull market have combined to send them soaring in the 2010s. For 2018, according to Morningstar Research, investors poured more than US$458 billion into index funds across all asset classes. For the same period, actively managed funds experienced $301 billion in outflows.
The one fund that started it all, founded by Vanguard chairman John Bogle in 1976, remains one of the best for its overall long-term performance and low cost. The Vanguard 500 Index Fund has tracked the S&P 500 faithfully, in composition and performance. It posts a one-year return of 9.46%, vs. the index’s 9.5%, as of March 2019, for example. For its Admiral Shares, the expense ratio is 0.04%, and its minimum investment is $3,000.
What is a mutual funds?
A Mutual Funds is an investment vehicle made up of a pool of funds collected from numerous investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual Funds are operated by professional fund managers, who invest the fund’s capital and attempt to produce capital gains and income for the investors.
Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is usually tracked as the change in the total market cap of the fund—derived by the aggregating performance of the underlying investments.
How a mutual fund works
A mutual fund is both an investment and an actual company. This dual nature may seem strange, but it is no different from how a share of AAPL is a representation of Apple, Inc. When an investor buys Apple stock, he is buying part ownership of the company and its assets. Similarly, a mutual fund investor is buying part ownership of the mutual fund company and its assets. The difference is that Apple is in the business of making smartphones and tablets, while a mutual fund company is in the business of making investments.
If a mutual fund is a virtual company, its CEO is the fund manager , sometimes called its
investment adviser . The fund manager is hired by a board of directors and is legally obligated to work in the best interest of mutual fund shareholders. Most fund managers are also owners of the fund.
There are very few other employees in a mutual fund company. The investment adviser or fund manager may employ some analysts to help pick investments or perform market research. A fund accountant is kept on staff to calculate the fund’s NAV, the daily value of the portfolio that determines if share prices go up or down. Mutual funds need to have a
compliance officer or two, and probably an attorney, to keep up with government regulations.
Most mutual funds are part of a much larger investment company; the biggest have hundreds of separate mutual funds. Some of these fund companies are names familiar to the general public, such as Fidelity Investments, the Vanguard Group, T. Rowe Price, and Oppenheimer Funds.
Types of mutual funds:
Mutual funds are divided into various categories which is targeted to the kind of securities portfolio and return someone is looking for.These includes:
The largest category is that of equity or stock funds. As the name implies, this sort of fund invests principally in stocks. Within this group is various sub-categories. Some equity funds are named for the size of the companies they invest in small-, mid- or large-cap. Others are named by their investment approach: aggressive growth, income-oriented, value, and others. Equity funds are also categorized by whether they invest in domestic (U.S.) stocks or foreign equities.
Another big group is the fixed income category. A fixed income mutual fund focuses on investments that pay a set rate of return, such as government bonds, corporate bonds, or other debt instruments. The idea is that the fund portfolio generates interest income, which then passes on to shareholders.
Other types of mutual funds are:
• Balanced funds
• Money Market funds
• Sector funds
• Target-date funds
• Alternative funds
• Smart-beta funds
Advantages of mutual funds
There are a variety of reasons that mutual funds have been the retail investor’s vehicle of choice for decades. The overwhelming majority of money in employer-sponsored retirement plans goes into mutual funds.
Diversification – Mutual Funds spread their holdings across various investment vehicles, reducing the effect any single security or class of securities has on the overall portfolio. Because mutual funds contain hundreds or thousands of securities, investors are less affected if one security underperforms.
Professional Management – Mutual Fund accounts are managed by qualified professionals. These professionals invest only after careful analysis of the performance and prospects of different securities. It is a continuous process that takes time and expertise which will add value to your investment.
Regulations – Mutual Funds are required to be registered with the Securities and Exchange Commission. They are obliged to follow strict regulations designed to protect investors.
Affordability – As a small investor, you may find that it is not possible to buy shares of larger corporations. With Mutual Funds
small investors can get started because of the minimal investment requirements.
Liquidity – With open-end funds, you can redeem all or part of your investment any time you wish and receive the current value of the shares. Moreover, the process is standardized, making it swift and efficient.
Transparency – As a unit holder, you are provided with regular updates, for example daily NAVs, bid and offer prices as well as information on the fund’s holdings and the fund manager’s strategy.
Disadvantages of mutual funds
Just like words and opposite- good and bad. Aside factors like Liquidity, diversification, and professional management, all these factors make mutual funds attractive options for a younger, novice, and other individual investors who don’t want to actively manage their money. However, no asset is perfect, and mutual funds have drawbacks too which are:
Like many other investments without a guaranteed return, there is always the possibility that the value of your mutual fund will
depreciate . Equity mutual funds experience price fluctuations, along with the stocks that make up the fund. The Federal Deposit Insurance Corporation (FDIC) does not back up mutual fund investments, and there is no guarantee of performance with any fund. Of course, almost every investment carries risk. It is especially important for investors in money market funds to know that, unlike their bank counterparts, these will not be insured by the FDIC.
Heavy Cash Supplies
Mutual funds pool money from thousands of investors, so every day people are putting money into the fund as well as withdrawing it. To maintain the capacity to accommodate withdrawals funds typically have to keep a large portion of their portfolios in cash. Having ample cash is excellent for liquidity, but money is sitting around as cash and not working for you and thus is not very advantageous.
Mutual funds provide investors with professional management, but it comes at a cost—those expense ratios mentioned earlier. These fees reduce the fund’s overall payout, and they’re assessed to mutual fund investors regardless of the performance of the fund. As you can imagine, in years when the fund doesn’t make money, these fees only magnify losses.
Diworsification—a play on words—is an investment or portfolio strategy. Many mutual fund investors tend to overcomplicate matters. That is, they acquire too many funds that are highly related and, as a result, don’t get the risk-reducing benefits of diversification. These investors may have made their portfolio more exposed; a syndrome called diworsification. At the other extreme, just because you own mutual funds doesn’t mean you are automatically diversified. For example, a fund that invests only in a particular industry sector or region is still relatively risky.
Other disadvantages of mutual funds are:
• Lack of transparency
• Evaluating funds.
Statistical examples of mutual funds on real word;
One of the most famous mutual funds in the investment universe is Fidelity Investments’ Magellan Fund (FMAGX). Established in 1963 the fund had an investment objective of capital appreciation via investment in common stocks. Fidelity founder Edward Johnson originally managed it. The fund’s glory days were between 1977 and 1990 when Peter Lynch served as its portfolio manager. Under Lynch’s tenure, Magellan regularly posted 29% annual returns, almost double that of the S&P 500. Both the fund and Lynch became household words.
Even after Lynch left, Fidelity’s performance continued strong, and assets under management (AUM) grew to nearly $110 billion in 2000, making it the largest fund in the world . By 1997, the fund had become so large that Fidelity closed it to new investors, and would not reopen it until 2008.
As of April 2019, Fidelity Magellan has over US$16 billion in assets and is managed by Jeffrey Feingold since 2011. The fund’s performance has pretty much tracked or slightly surpassed that of the S&P 500.