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Tuesday, January 5, 2010

Managed Mutual Funds Vs Index Funds

Those of you who have just started investing may have heard the terms "actively-managed mutual fund" and "index fund" thrown around by personal finance advice columnists, bloggers, and the financial media. This financial jargon may sound like Greek to you, and intentionally so, since the financial media needs for investing to seem difficult in order to continue selling newspapers and magazines. The truth is, investing is easy, and learning the difference between actively-managed and index mutual funds could very well be your first step towards financial prosperity.

The Two Flavors Of Mutual Funds

Mutual funds basically come in two flavors: actively managed and index. Both own a diversified portfolio of stocks or bonds and both pool the money of millions of investors around the nation into one large fund, giving investors wide diversification for a relatively small amount of money.

Actively managed mutual funds are the more glamourous of the two. Managed funds have one goal: to obtain above-average returns, often paying hot-shot managers outrageous sums of money for a shot at winning big. So what's the problem? Unfortunately, the vast majority of actively-managed mutual funds fail to outperform the market, which is usually measured by the S&P 500 index. That doesn't stop them from charging large fees, however. Actively-managed funds are like going to Vegas: you could win big, but you probably won't. In most cases, you'd be better off not trying.

Index funds, by contrast, merely seek to match the market. For example, an S&P 500 index fund will merely buy the same stocks in the same proportions as the index and leave it at that. Since they don't have to hire expensive managers, index funds are very inexpensive relatively to actively-managed funds, and generally outperform them as well due to that same cost advantage. The downside is that it is impossible to outperform the market. With index funds, you have to take your pick: would you prefer average returns with no shot of beating the market using index funds or mostly below-average returns with a shot at above-average returns using managed funds? Vanguard is the company responsible for inventing index funds and is still by far the most respected in the industry.

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