Index Funds and Mutual Funds

Whether money is be the root cause of evil or not, I don”t know. What I do know it that since the dawn of man, the concept of currency had been intimately intertwined with human society. It helps form the basis of governments, and most laws. The world stock market is where these global force that powers our atomic age society merges into a complex matrix of financial void; opportunity in it”s most complex form.

The raw power of the stock market that can either bring a man to rapid success, or completely ruin him. Two of the prominent worlds of the stock market are the topic for this research paper: Index Funds and regular mutual funds. To my horror, these two terms are incredibly vague words and each have many different parts with their own specific characteristics. I will be comparing and contrasting the over shared characteristics of both kinds of stock market investing. Let us begin by explaining what both these terms actually mean.

Indexing, in its simplest form, means buying all of the stocks, bonds or other instrument of a market, or asset class, instead of trying to pick winners and losers. Index investors are content with the average performance of a market. When they invest, they buy all an amount of all the stocks within the index with the knowledge that some individual stocks will gain and some will lose. The hope and assumption is when investing in index funds, that the overall net change of all the stocks in the index average out to a gain. This is usually the case as the normal trend for a market is to gradually climb. Index investors are skeptical that on average a money manager can improve on the average performance without raising risk. They are even more skeptical after fees are subtracted.

The best known index, the Standard & Poor’s 500 (S&P 500), is a collection of the top 500 major US stocks. However there are dozens of others, including the Euro Top 100, the largest European stocks; EAFE, a broad global index of companies from numerous countries; and the Lehman Brothers Aggregate Bond Index, a collection of government and commercial bonds.

Other names for index investing include “asset class investing” and “passive investing.” As the name suggests, passive investing is basically a no brainier. The philosophy is not to worry about what individual stocks will gain or lose but to place your risks on the market as a whole. An asset class is simply a category of investment, such as stocks or bonds.

No surprises – You instantly know whether your gaining or losing as your profits are based on the overall conditions of the market, or at least the section of the market you invested in. With an actively managed mutual fund investment, you may not know until the very end that the fund manager just lost you or gained you a great deal of free money.

Low maintenance – No thinking required. In this sense its kinda like a slot machine just on a much larger scale and on a slot machine… you never win. There is no debating over which stocks to buy, for how long to keep them. Your money stays put; you always know where it is unlike mutual funds where its always being shuffled around.

Low Taxes – Taxes on distributions among shareholders is significantly less with index funds as opposed to mutual funds. This saves time and money.

Low Expenses – Stock managers charge money. The better they are, the more they charge which boils down to the more you make, the more is taken out of you profit. The average general stock fund takes 1.5% of your assets each year for expenses. Some funds charge much more. The average index fund charges only 0.46%, which means more of your money, is left behind.

Lower risk – As you invest in an index, your stocks are generalized throughout the market. This diversification holds a lower risk then picking out individual stocks yourself.

Average returns – Investing in an index fund means you’ll never beat the market. You’ll never even match it, since fund expenses will knock a little off your returns. And even though most actively managed mutual funds don’t beat the market over time, a few managers have consistently posted outstanding performances.

No downside protection – Mutual fund managers often increase their holdings of bonds and cash if they think the market is poised to fall. Index funds offer no such safeguards: If the market plunges, you’ll go down with it. That’s why most financial planners say index funds are best suited for long-term investors who can ride out dips in the market.

High minimums – While index funds generally have low expenses, you may need a lot of money to get started. For example the Vanguard fund requires an initial investment of $3,000 to go into one of its popular index funds; other funds require $1,000 to $5,000. And once you’re in, it might be expensive to get out: Many index funds charge a fee to investors who don’t hold onto their shares at least a year, or more.

No fun – Like I said, it”s a no-brainer. Which means you sit and watch your money travel up and down a little red line on you television screen while watching CSPAN. Not as exciting as getting the newspaper the next day and finding out your fund just quintupled.

A mutual fund is a company that combines, or pools, investors’ money and, generally, purchases stocks and/or bonds. Ideally, a fund’s size and efficiency, combined with experienced management, provide advantages for investors that include diversification, expert stock and bond selection, low costs, and convenience. In terms of legal structure, a mutual fund is a corporation that receives preferential tax treatment under the U.S. Internal Revenue Code. The most common type of mutual fund, called an open-end fund, allows investors to buy and sell stock in it on an ongoing basis.

The mutual fund issues shares of stock to investors in exchange for cash. However, unlike most cooperations do, mutual funds don”t issue a set amount of shares; new shares are issued as each new investment is made. Investors thus become part owners of the fund itself, and thereby the assets of the fund. The fund, in turn, uses investors’ cash to purchase securities, such as stocks and bonds. This makes up the majority of the assets that the fund makes for itself.

There are two main types of mutual funds, a load and no-load fund. Basically speaking, a load fund is one that has a sales charge, and a no-load does not. Those that do have sales charges simply add them on to the net asset value of the fund, thus coming up with a new, higher offering price per share. The underlying values of the fund”s shares do not change. An investor selling shares will still receive only the net asset value. A no-load fund is simpler. The net asset value is used for both the purchase price and the selling price. Therefore, the two prices are always the same.

Diversification – As opposed to independent stock investing. Your money is more diversified but not as

Cost – Again, as opposed to individual investing. Funds usually have trading cost discounts and can spread internal cost over the large shareholder base.

Professional Management – You have a professional fund manager who watches the stock and decides where it should go and when it should go there.

Tax planning difficult – because the timing of taxable distribution is uncertain. You cannot choose the sale dates for yourself and therefore there is much uncertainty on when your taxable distributions are made.

Uncertainty – For competitive reasons with other mutual funds, the funds usually don”t disclose the report of a transaction until after its been made. This leaves you constantly one step behind in knowing where you money is.

Manager changes – A fund can all of a sudden change a manager which you will not find out about in a timely manner. You don”t know who”s handling your money and have little control over it yourself.