Investing in index funds and mutual funds is a popular option for savvy investors who want to save up early for retirement. Yet, this financial approach is not a one-size-fits-all option. And learning the critical aspects of these investment types is a must for anyone who wants to give it a try.
Index funds and mutual funds may sound quite similar, but these two differ in many ways. In this post, you’ll learn the difference between these two and which type will best suit your profile.
What Are Index Funds?
An index fund is a type of mutual fund designed to mimic or match the performance of a benchmark index. Index funds are made of stocks, bonds, and other securities typically managed by fund managers.
These funds have a broader market exposure, low portfolio turnover, and lower expense ratio than actively managed mutual funds.
How Do Index Funds Work?
Investing in index funds is one of the easiest ways to build and grow your wealth. And, you can do this even without being an expert in the stock market.
Indexing is a form of passive fund management. With an index fund, investors buy securities within the aligned index wherein the goal is to replicate a benchmark market’s performance simply. Aside from fund managers, you can also access index funds through brokers and online trading platforms.
Investing in index funds involves these processes:
1. Picking The Index
There are several hundreds of indexes you can track using index funds, and the most popular one is the S&P 500 Index. You could also choose country indexes that target stocks in a specific country. In Singapore, one popular index is the Straits Times Index (STI), which comprises stocks from 30 representative companies listed on the Singapore Exchange.
2. Choosing The Right Index Fund
After choosing the index, find an index fund that tracks it. Some key points that are relevant to selecting an index fund are:
- Closely tracks the performance of the index
- The cost and features
- Comparing index funds that interest you
3. Buying Index Fund Shares
To buy index fund shares, you can:
- Open an account with the mutual fund company. It is also cheaper to buy index funds directly rather than brokers.
- Open a brokerage account with a broker. This option is best for individuals who plan to invest in several index funds for easy management and monitoring.
- Opt for broker-assisted services. This service is ideal for new investors who still need guidance in this investment field.
1. Low expense ratios
Index funds have lower total expense ratios (TER) than mutual funds simply because you don’t need to pay someone to manage your account.
2. Lower taxes for investors
Most index funds have a low turnover ratio and return fewer dividends, thus, producing less income tax.
3. Ideal for buy-and-hold investors
Index funds are a good option for investors who want to use the buy-and-hold strategy for a long-term bet.
4. Better long-term returns
Index funds, being passively managed, will yield a slow but dependable return over long years.
5. It does not require investing expertise.
Investing in index funds doesn’t necessarily require technical research and know-how in this field.
1. Lack of flexibility
The fund manager cannot make any changes to the portfolio under policies. Thus, they will not be able to limit losses when index returns are declining.
2. Limited returns
Index funds tend to perform steadily, making the possibility of massive gains little to none.
3. Vulnerable to market swings
Fund managers cannot adjust the holdings at their discretion and don’t have a way to defend their funds against extreme market conditions.
What Are Mutual Funds?
A mutual fund is a company that pools money from a group of investors and invests it in a collection of companies. Like index funds, mutual funds also invest in a list of securities chosen by a fund manager.
Each mutual investor owns shares and receives a proportionate share in the fund’s profits and losses.
How Do Mutual Funds Work?
Mutual funds are actively managed funds where the main objective is to outperform the market index. Investors get to start investing by opening a brokerage account or getting a money manager. Investing in these funds will also come with transaction and management fees, mainly because it involves active management.
Here, the investment manager will regularly buy and sell shares with mutual funds to maximize potential gains. An actively managed mutual fund may have higher returns, but this is not guaranteed as market performance may also be unpredictable.
Usually, mutual fund brokers will require a minimum investment, but you may also find some that don’t.
Common Types of Mutual Funds
1. Equity Funds
This mutual fund type focuses on equities like stocks and shares. Equity funds are further listed into sub-categories which are:
- Company size
- Investment approach
2. Fixed-Income Funds
Fixed-income funds focus on debt instruments like government and corporate bonds. However, be wary of the risk involved with investing in this type, as fixed-income assets may come with high-interest rates.
3. Index Funds
As earlier mentioned, an index mutual fund is also made up of stocks and bonds. However, the principal objective of indexing is to simply track the performance of an index to produce good results.
4. Specialty Funds
Specialty funds focus on a particular sector or industry, such as technology, real estate, or luxury assets.
5. Balanced Funds
As the name suggests, balanced funds spread out an investment across several assets. These mutual funds are ideal for investors who want to preserve their capital.
How To Buy Mutual Funds in Singapore?
1. Open an account with an online brokerage: Choosing reputable brokers and understanding all the rules and regulations are essential.
2. Check with your bank: Some banks may offer mutual fund products as part of their investment services.
3. Check with private insurers: If you are not yet subscribed to an investment-linked policy (ILP), you may be interested in getting one. ILPs may offer mutual funds to their insurance policy’s investment funds as a sub-fund.
Note, however, that the first two options are the most sought-after methods. Many investors prefer to keep their investments separate from their insurance.
- Offers easy diversification of your investment portfolio: A wide range of mutual funds is available that allows you to focus on different sectors, industries, and assets.
- Easy access: Aside from online platforms and brokers, you may also invest in these funds through banks and other investment firms.
- High liquidity: Like individual stocks, index funds are highly liquid, and you can quickly sell out your shares, in whole or partial, anytime you need cash.
- Professional management: Expert investment professionals will manage your accounts with a fee.
- Higher fees, including commissions and other charges: With mutual funds, shareholders pay these fees through an automatic reduction in funds’ price, which significantly impacts the overall gains. Additionally, an actively managed fund incurs taxes and fees every time a fund sells a holding.
- Investment returns may fluctuate with underlying assets: Mutual funds may experience fluctuations along with stocks that make up the fund.
Index Funds Vs. Mutual Funds
Index funds and mutual funds can be confusing, especially for beginners. So, let us understand some distinct differences between the two investment vehicles.
1. Investment Options
Index funds invest in a specific list of securities, while a mutual fund invests in a changing list of securities. However, both invest in stocks, bonds, and other securities.
2. Investment Objective
The main objective of an index fund is to match the benchmark index performance. On the other hand, a mutual fund’s goal is to beat the investment returns of a related benchmark index.
3. Management Style
Index mutual funds are passively managed or automated to match the index’s actual returns. While for mutual funds, you will need active human involvement through a professional fund manager to decide on investment funds and monitor their performance.
4. Costs And Fees
Index funds come with low investment costs since they are passively managed. While actively managed mutual funds usually involve an expense ratio that covers the operational fees such as office space rent, marketing, and other costs. These high fees may have a significant impact on potential gains.
Where Should I Invest In?
Choosing where to invest your money ultimately depends on your investment goals, investment experience, and risk profile.
1. Choosing to Invest In Index Funds
The most obvious benefit of investing in index funds, aside from being a passive investment, is that your portfolio becomes instantly diversified. Diversification reduces the risk of losing your money since the value of your portfolio is not tied to any one company listed in the index.
Investing in index funds is ideal for new investors who want a no-fuss and easy-to-access investment. Plus, you’ll enjoy a more significant percentage of returns on your investment with low management fees.
This type of investment is also for investors who seek a “set it and forget it” approach that yields steady investment returns over a long period.
Find more about the best index fund in Singapore.
2. Choosing to Invest In Mutual Funds
Investing in mutual funds is a perfect option for investors who don’t want to take the DIY approach to start investing. The fund manager will be responsible for decision-making with mutual funds, and you just have to wait for the returns.
Actively managed mutual funds are also ideal for investors looking for better flexibility. This flexibility allows fund managers can quickly move and change assets, especially in crucial periods. An actively managed mutual fund could also offer better opportunities for significant gains than index funds.
Want to know more? Check out the difference between ETF vs Mutual Fund vs Unit Trust.
Like other investments, index funds and mutual funds still have some risks. So, whether you decide to invest in index funds or mutual funds, you should still consult an investment advisor for expert opinion. You should also back up your investment decisions with some readings and determine the best fit.
- The right investment product and technique will depend on your investment goals and risk profile.
- Low management costs mean higher investment returns for shareholders.
- If you’re going for actively managed mutual funds, choose a reputable investment manager that can protect and grow your portfolio.
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