So, you have a retirement account, but do you know what you are investing in? Mutual funds? Index funds? ETFs? What are they? Why do they matter? Well, read on…
There are mutual funds, index funds, exchange traded funds (ETFs). These funds are either actively managed or passively managed.
In actively managed funds, a team of investment professionals actively pick the fund’s holdings and adjust them as needed. They make daily or even hourly trading decisions, trying to outperform the market. The expense ratio, the fees used to manage the fund, is usually high. The average expense ratio for an actively managed fund is about 1%, it can be lower or higher.
Passively managed funds are automated to track a market index such as the S&P 500. Since nobody is actively managing the holding, the expense ratio is low. The average expense ratio for a passively managed fund is between 0.05% to 0.07%.
A good expense ratio is <0.5%, but really anything less than 1%.
Index funds – refers to a fund whose investments closely track a market index, such as the S&P 500. An index fund does not seek to beat the market, only to match it.
- Index fund takes a passive approach. There is no fund manager actively managing the fund since it is tracking the performance of a market index.
- Index funds buy and hold securities
- Lower expense ratio
Mutual funds – refers to a broad class of investment funds that follow a range of investing strategies. Many, but not all mutual funds are actively managed.
- Mutual funds buy and sell securities, since they are actively managed
- The objective is to outperform the market
- Mutual fund investors seek higher-than-average returns
- Higher expense ratio
Many index funds are structured as mutual funds and many mutual funds are index funds. It can get very confusing, even for me.
Exchange traded fund (ETF) is a collection of stocks or bonds in a single fund and function similarly to index funds. Some index funds require a minimum investment, ETFs do not.
In conclusion, you want to pick a fund that has good returns and low expense ratio. You are in it for the long run. The lower the management fees, the more you can receive in returns. The higher the management fees, you may receive lower returns.