In index mutual funds and ETFs, the stocks or bonds included in the fund are selected according to a rule. For example, a fund might buy the stocks of companies included in the Standard & Poor’s 500 index (the 500 largest companies in the stock market); another fund might concentrate on stocks of small companies; yet another fund might buy short-term government bonds; and so on. In an ideal index fund, there is no stock picking of individual stocks. Most ETFs are index funds.
In reality, many mutual funds are a mix of managed funds and index funds, where managers pick stocks or bonds within a certain category of issuers. For example, picking the “most promising” companies in the communications industry.
Which is better, a managed fund or an index fund?
There is no general answer to this question. Some managed mutual funds are better than some index funds, and some index funds are better than some managed funds.
My advise is simple: don’t dwell on whether a fund is a managed fund or an index fund; just concentrate on the fund’s return – you want a fund that makes the most money for you, be it a managed fund or an index fund.
How do you choose a great mutual fund or ETF?
Your return is the amount of money you make by investing. Let’s look at the main factors that determine your return.
How much does it cost to invest?
Well – investing is not free… it costs money to invest in financial instruments. So let’s look at the different kinds of expenses involved in investing.
Mutual fund purchasing fees
Some mutual funds impose a fee when you buy shares of the fund; these fees are usually in the range of 1% to 5% of your investment in the fund. Purchasing fees become a problem, if you trade your shares often. These fees will accumulate and chew up your earnings, or, worse, cause you to lose money on your investments. You can find out whether a fund imposes purchasing fees by checking the fund’s prospectus under ‘fees’.
My recommendation is simple: don’t invest in mutual funds that impose purchasing fees.
Mutual fund redemption fees
Some mutual funds impose a fee when you sell shares of the fund; these fees are usually in the range of 1% to 5% of the amount of money you redeem from the fund. As in the case of purchasing fees, redemption fees become a problem, if you trade your shares often. These fees will add up and spoil your earnings, or, worse, cause you net losses on your investments. You can find out whether a fund imposes redemption fees by checking the fund’s prospectus under ‘fees’.
My recommendation is simple: don’t invest in mutual funds that impose redemption fees.
I should mention here that ETFs do not impose purchasing fees, nor do they impose redemption fees.