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Mutual Funds Index - What's the Difference Between Mutual Funds and Indexed Mutual Funds?

market stock value shares

When an investor wishes to enter a market, but minimize overexposure to any single segment or entity, indexed mutual funds are often a good investment choice. The purpose of mutual and indexed mutual funds is to minimize risk by diversification of assets. Mutual funds pool dollars from a group of investors and maintain a portfolio of diversified stocks, bonds, treasuries, futures or nearly any combination of the above type of investment. Non-indexed mutual funds are actively managed with the goal of picking underpriced investments. This requires intensive research to consistently find new investments and shed overpriced investments before the market’s efficiency restores the investment to its correct pricing. Mutual fund managers, who can demonstrate a track record of beating the market, i.e. consistently outperforming the return of the index as a whole, can command high fees.

Indexed mutual funds operate under a different assumption, rather than attempt to actively seek mispriced investments, an indexed mutual fund attempts to correlate closely to an entire market and capitalize on the efficiencies and natural growth of its constituents. An indexed mutual fund based, for instance, on the Standard & Poor’s 500 (S&P 500) ideally owns stock in all of the companies represented in that index and in the same proportion. This feat would be impractical for most individuals due to the substantial amount of capital required to own even one share of 500 different companies and the thousands of dollars in commissions and fees necessary to maintain them in the correct proportion.

Indexed mutual funds and non-indexed mutual funds both mix investments to limit the impact of any particular stock or bond or investment, but indexed funds are passively managed rather than rely on the active research and predictions of a fund manager. This passive management allows index funds to keep substantially lower fees and commissions, typically less than .5% versus 1% or higher for non-indexed funds. Investment changes are determined by changes in the total market’s value as spelled out in the fund’s prospectus. For instance, an index fund tied to the S&P 500 may require 90% of the fund’s value be invested in constituents of the index, the balance remaining available for redemptions and fees. As the value of individual shares in the market changes, the fund manager would routinely adjust the quantity of shares in the fund portfolio to match the float-adjusted market value of shares within the index.

To see how this might work, image the above-mentioned fund rules apply to a fictional market with only three stocks, Stock A has 100 outstanding shares at $10, Stock B has 50 shares at $12, and stock C has 300 shares outstanding each priced at $5. The total value of the market is $3,100 ((100 x $10) + (50 x $12) + (300 x $5)). To correlate to the market, the manager would be required to maintain 32.3% of the fund in stock A, 19.4% in stock B, and 48.4% in stock C, minus the fund’s needs for redemptions and fees. These figures represent the relative values of each stock to the total value of the market, $3,100. If stock A and B have a good day and each gain 50 cents, but stock C declines by 50 cents, the index fund manager changes the proportions to A 34.7%, B 20.7%, and C 44.6%, but note the total value of the total market has still declined to $3,025, and the value of our fictional mutual fund has declined accordingly. This illustrates an important point: Simply because a stock may be lower in price, the total capitalization is the key to its impact on the market as a whole.

Indexed mutual funds have grown increasingly popular since their inception in the 1950’s. Some non-indexed funds may beat the market several years in a row, but the overall efficiency of the market, i.e. other investors, conspire to work against this. Thus, indexed mutual funds may never return the spectacular results of a fund manager’s best year; they are extremely likely to outperform his or her career average.

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