Both managed mutual fund and index fund managers purchase stocks and bonds to create diversified portfolios and then allocate shares of these portfolios to investors. While these two types of mutual funds offer diversification and more reliable returns than individual stock investments, an investor can gain a higher yield with less risk by adding the right type of mutual fund to his portfolio.
Index funds can contain bonds but more frequently are composed of stock. They usually track an overall stock index, such as the S&P 500, or a particular industry, such as retail businesses or energy providers. Managed mutual funds typically mix baskets of equities together from different market sectors and more frequently award dividends to investors.
Index funds have few fees because they need few analysts, don’t have to overpay fund managers and pay fewer costs for advertising. Managed mutual funds commonly charge fees between one percent and two percent of average annual portfolio value, while index funds charge between one-tenth and one-fourth of the cost by comparison.
With managed mutual funds, investors usually have to pay backend loads charged to sell shares if they hold onto their investments for a short time. With index funds, investors can unload their shares at any time without penalties. Popular index funds have a high trading volume, which means investors can more easily sell their shares on the open market.
Actively managed funds may generate higher returns on paper, but expenses and higher taxes cut into profit margins. Fund managers also have to maintain a cash cushion to protect against market selloffs. Since index fund portfolios remain relatively constant, managers do not concern themselves with cushions. Managed mutual funds offered a rate of return one percent less than that of general index funds over the past 23 years, according a 2009 study by the Wharton School of the University of Pennsylvania.
Turnover describes the rate at which a fund manager or investor sells equities and purchases new ones. An investor who has a $10,000 portfolio, sells all his stock every six months and purchases new stock, turns over his portfolio twice a year. Active mutual fund managers can completely turn over equities in fund portfolios in less than a year. They do so to maximize opportunities for returns and cut losses. While index funds drop existing stocks and add new stocks to a portfolio on an irregular basis, stocks that comprise the index remain relatively constant.
Managed mutual funds have a higher tax liability at the state and federal level than index funds. The Internal Revenue Service does not consider gains on paper as taxable until a mutual fund manager makes a sale. The rapid turnover in a managed mutual fund will cause many taxable events. Since stocks in an index fund rarely change, profits can accumulate tax free, allowing an investor to receive a higher return.
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