On the surface, index funds and mutual funds may seem interchangeable; both offer diversification of assets and are commonly invested in a basket of stocks that aim to meet certain investment goals. However, there are many key distinctions between the two that may be crucial to your portfolio of retirement investments.
The Breakdown of Index Funds
Index funds invest in a specific list of securities, such as a Dow Jones Industrial Average or S&P 500 index, that track stocks based on certain factors. The Dow Jones is a qualitative index that tracks 30 blue-chip (which are well-known and crucial to the US economy) industrial and financial companies in the United States. The index is used by the media as a barometer of the broader stock market and the economy. There are many other indexes that track different stocks or securities and have different criteria for companies to get added or dropped from them.
Brokers will offer funds that allow you to buy a basket of stocks that correlates to an index. Index funds may track the same index but differ in how each stock is weighted inside the fund. Some funds may also favor or screen out sectors or stocks with certain technical or fundamental traits to meet a specific investment goal.
Overall, Index funds simply track the market in some form or another with less of a focus on “beating” the market. They are also passively managed, only really changing based on the stock index, not a manager’s decisions.
The Mutual Fund Difference
Mutual funds often invest in a changing list of securities chosen by an investment manager. They may provide you with more diversification and a greater range of options but are often more expensive in fees. In addition, a mutual fund’s aim is to specifically meet an investment goal and to “beat” the market, in other words, they are actively managed.
Over the course of many years, longer than any one person’s life, index funds outperform mutual funds on average, especially when factoring in the fees charged. However, those fees may be worth it when specific investment risks are covered, and you benefit from increased diversification and flexibility.
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