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Mutual Funds vs Index Funds: What’s the difference?

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Mutual Funds versus Index Funds

Yes, it does all sound like Greek. Mutual Funds, or collective funds or just plain old ‘funds’ may just be your best friend if you’re picking a Stocks and Shares ISA. They pool your investment with those of other people, giving you access to a broad range of shares all in one place. Simples.

However, that would be too easy for the investment industry, which likes to mix things up a little. In its wisdom, it has decided to give you the choice of thousands and thousands of funds. So, while investing in funds should be simple, it’s also quite complicated because you have to choose which one you want.

 

Active versus Index

This is really your key decision. You can either pick a fund that tracks an index, such as the FTSE 100 or S&P 500, or you can pick an active fund, where a fund manager will use their skill and experience to pick the stocks they believe will give the strongest return over time.

The reasons you would choose one or the other are myriad, and it’s really down to personal choice. Here are a few thoughts:

  • Index Funds tend to be cheaper.
  • Many active funds don’t add value over and above the index, but a good one can add a lot to your returns.
  • Index Funds will tend to be concentrated in the largest stocks – expect HSBC, GSK, Shell, BP or similar.
  • Index Funds can’t move out of companies that look like they’re heading into difficulties.
  • Ethical Investing (ESG) considerations – the best companies act responsibly. An index approach may not pick up on this.
  • All indices have certain biases – indices will have significant weights to certain sectors or countries. This may be good or bad, but you should know what you are getting.

 

Index Funds

So, what’s a financial index? An index is a just a group of shares. Usually, they are grouped by size. The FTSE 100 index, for example, is the 100 largest companies in the UK stock market. The S&P 500 index is the same in the US. However, there are indices that look at criteria other than size – the Nasdaq, for example, focuses in on the leading technology companies. Index Funds just track these indices up and down. They may not call on whether one share is better than another. If it’s in the index, they’re invested.

An active fund will usually charge around 75p for every £100 you entrust to them. An index or passive fund, in contrast, will only cost you around 12-17p for every £100 and ETFs (which are a type of index fund that trades on an exchange – see below) may be even cheaper. This may not sound a lot, but it can add up over time. At 5% growth, a £20,000 investment would grow to £54,250 over 20 years. Knocking 0.5% off for costs would reduce this to £49,100. More than just a few jangling pennies.

 

Active funds

The alternative is an ‘active’ fund, where a fund manager aims to use their experience and skill to find the best investments. An active fund manager by definition thinks they are smarter than the average investor. A clever clogs. They think they can spot a bargain or spot the dog before others. Identify the region that is about to go belly-up. The problem with this approach is that you take a risk on whether the fund manager gets it right or not, and you also pay a bit more.

The active manager will argue that not only can they decide which companies are good and bad, focusing on the good ones and dismissing the bad ones, they can also pick smaller emerging companies that aren’t in the index. This type of company can grow very fast and give your portfolio a boost over and above the index performance. Someone looking at what to put in their Stocks and Shares ISA will need to decide whether they want to take that risk.

 

So, what should I do?

Going with a passive fund or ETF doesn’t completely absolve you of choice. You will still have to decide where you want to invest – which country, which sector and so on. A popular way to manage a Stocks and Shares ISA is to hold the main bit of your portfolio in passive funds, with a few active funds scattered around the edges to ‘pimp your ride’.

If you really haven’t got the foggiest, and I’m making you feel weak, have a look at Vanguard’s LifeStrategy, BlackRock Consensus funds or Legal & General, and see what you think. These are low-cost passive funds tailored for different risk levels. You just need to decide what the split between bonds and equities should be (how ‘spicy’ your investment should be) – and they help you think about this.

 

Where to buy them?

The last thing you want to do is buy a super-cheap passive fund on a mega-expensive platform. All the funds mentioned above are available on platforms, but you need to check how much you’re paying in costs as well. See what we like in our Online Investments Product Guide.

Fidelity has some passive funds available on their platform and – with a platform fee of 0.35% – this can make for a low-cost way to stick a toe in the investment water. Again, if you’re feeling a bit bamboozled, look at Fidelity’s Pathfinder Foundation Range. This is a low-cost passive range of funds where the people at Fidelity have made the decisions about bonds vs shares as well as what funds to buy.

 

A note on ETFs

‘ETFs’ or Exchange Traded Funds are a type of index fund, but they are bought like shares. This means that you may pay a one-off charge every time you buy and sell them (funds are typically free to buy and sell). This makes them a poor choice for regular savings, though some platforms have got wise to this and have amended their charging structure.

ETFs are super-cheap and available for all the major indices – FTSE 100, S&P 500 and so on, but you’ll need to get them through a platform that offers share trading – The Share Centre, Barclays Smart Investor, Hargreaves Lansdown or Interactive Investor. If you’re investing small amounts, look for a platform which charges a % fee, not a fixed £ fee, and stick with funds. Charles Stanley DirectBestinvestFidelity and Hargreaves Lansdown are examples. If you’ve got mega bucks, check out Alliance Trust Savings or Interactive Investor, because their fixed £ fees should reduce your overall cost.

 

The choice is yours

Mutual Funds are a good way to get started in investing. In terms of the growth in your long-term savings, having one is usually better than not having one, so don’t stress too much about picking the absolute best option. Just stick one in that Stocks and Shares ISA, top it up every now and again and see how it goes.

 

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