The Difference Between an Index Fund and a Mutual Fund

by Karen Farnen

Mutual funds allow you to invest broadly with a relatively modest amount of cash. As CNN Money explains, even a $2,000 investment in funds allows you to diversify over many securities. In addition, mutual funds spare you the trouble of hands-on management. You can select among funds that purchase different types securities, such as stocks or bonds. Index funds are a particular type of mutual fund with special advantages.

Fund Basics

A mutual fund is an investment instrument or company that places the combined funds of multiple investors in a particular type of investment. The mutual fund must have U.S. Securities and Exchange Commission registration and follow SEC regulations. Normally, the investment advisers who manage the fund's portfolio are separately registered. The share price is the total value of all securities in the fund divided by the number of shares. This price is called the net asset value, or NAV, and changes with the market.

Buying and Selling

Unlike stocks, you can't buy mutual funds on any stock exchange. You purchase shares directly from the mutual fund or through a broker. In addition to the net asset value, your price per share usually includes sales fees, or loads. Likewise, you redeem shares by selling them through a broker or directly to the mutual fund company, when you may pay a redemption fee. You can usually buy and sell shares at any time, but some funds stop accepting new buyers.

Types of Funds

Mutual funds come in many varieties, depending upon the investments in their portfolios. The different types of funds normally charge various management fees. Money market funds purchase low-risk investments, such as government securities or certificates of deposit. Stock funds invest mostly in stocks or equity shares of companies, whether U.S. or international. Shares of a stock fund decline if the companies it holds lose value. Bond funds invest in various types of debt that pay interest, including corporate bonds and municipal bonds. Some stock or bond funds are also index funds.

Index Funds

An index fund is one that tries to imitate a specific stock or bond statistical index. For example, some funds copy Standard and Poor's well-known S&P 500 Composite Stock Price Index of large U.S. stocks. Other funds track indexes for foreign markets or specific market segments. An index fund achieves its objective by purchasing all the securities in the index or a cross section of them. Some index funds also include other investments, such as commodities futures. In general, however, an index fund is supposed to mirror the gains or losses of the index it copies.

Benefits and Disadvantage of Index Funds

Actively managed funds pay a lot of money for research and salaries but usually don't outperform the market, according to CNN Money. An index fund requires less research and hands-on trading, resulting in lower fees and higher returns. In addition, less trading results in smaller capital gains and lower taxes. However, the management of an index fund often has less flexibility to protect your investment in a declining market. The fund normally has to keep the securities in its index even when their value falls.

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