ACCOUNTANT EXPLAINS: Mutual Fund vs Index Fund - Know the DIFFERENCE

Summary

In this video, Willis, a chartered accountant, explores the differences between mutual funds and index funds, crucial for investors. He explains mutual funds as professionally managed, diversified investments with potential for higher returns but significant fees. Index funds, on the other hand, are passively managed, tracking a benchmark index like the S&P 500, offering lower fees and mimicking market performance. The video guides viewers on choosing the right investment vehicle based on their risk tolerance and financial goals, emphasizing the importance of diversification and fees in investment decisions.

Takeaways

• 📈 **Understanding Shares**: Owning a share of a company means owning a small percentage of its assets and profits, and being entitled to a portion of its dividends.
• 🚫 **Risk of Individual Shares**: Investing in a single company's shares is risky because it concentrates your investment, potentially leading to significant losses if the company's performance declines.
• 💼 **Purpose of Mutual Funds**: Mutual funds were created to mitigate the risk of investing in individual shares by offering a diversified portfolio managed by professionals.
• 🌐 **Mutual Fund Composition**: Typically, mutual funds include a mix of stocks, bonds, and other securities, aiming to spread investment across various assets.
• 💹 **Growth in Mutual Fund Ownership**: The number of US households owning mutual funds has significantly increased from 5.7% in 1980 to 52% in 2023.
• 💼 **Benefits of Mutual Funds**: They offer professional management, diversification, potential for higher returns, and customization based on risk tolerance and investment types.
• 💸 **Mutual Fund Fees**: The average annual fee for mutual funds is 2.81%, which can significantly reduce investment returns over time.
• 📊 **Index Funds vs. Mutual Funds**: Index funds track a benchmark index and are passively managed, unlike actively managed mutual funds, leading to lower fees and potentially better long-term returns.
• 🏦 **Vanguard's Role**: Vanguard, founded by John Bogle, is a prominent provider of index funds, offering low-cost options that aim to match the performance of various market indices.
• 💰 **Cost Savings with Index Funds**: Over a 30-year period, the difference in fees between mutual funds and index funds can lead to substantial savings, highlighting the advantage of lower-cost index funds for long-term investing.

Q & A

What is the primary difference between a mutual fund and an index fund?

A mutual fund is actively managed by a professional investment manager and invests in a diversified portfolio of stocks, bonds, and other securities. An index fund, on the other hand, is passively managed and aims to track the performance of a specific market index, such as the S&P 500.

Why might an investor choose a mutual fund over an index fund?

An investor might choose a mutual fund for the professional management, potential for higher returns compared to individual stocks, and the ability to customize the investment to suit their risk tolerance and investment preferences.

What are the key benefits of investing in mutual funds?

The key benefits of mutual funds include professional management, diversification to spread risk, potential for higher returns due to diversification, and the ability to customize investments to fit individual risk profiles.

What is the main advantage of index funds over mutual funds?

The main advantage of index funds is the lower fees due to passive management, which can lead to higher returns over the long term, and the inherent diversification that comes with tracking an entire market index.

How do fees impact the returns of mutual funds?

Fees can significantly impact the returns of mutual funds. For example, a 2.81% annual fee on a 7% annual return represents a 40.1% fee on the return, which can substantially reduce the overall investment gains over time.

What is the average fee for mutual fund investments?

According to a recent study, the average fees for mutual fund investments are 2.81% per year.

Who is John Bogle and what is his connection to index funds?

John Bogle is the founder of Vanguard, an investment management company that promotes index funds. He established Vanguard in response to the high fees associated with mutual funds, aiming to offer a lower-cost investment option for investors.

What is the Vanguard 500 ETF and how does it work?

The Vanguard 500 ETF is an index fund that tracks the performance of the S&P 500 Index. It aims to match the performance of the index by investing in the same companies that make up the S&P 500, providing diversification and a low-cost investment option.

How do index funds manage risk?

Index funds manage risk through diversification by investing in a broad market index. This spreads the investment across many companies, reducing the impact of a poor performance by any single company on the overall portfolio.

What is the annual fee for the Vanguard 500 ETF?

The annual fee for the Vanguard 500 ETF is 0.04% per annum, which is significantly lower than the average fees for mutual funds.

How do the fees of index funds compare to those of mutual funds over a 30-year period?

Over a 30-year period, with a starting investment of $1,000 and a 7% annual return, the fees for a mutual fund with 2.81% fees would amount to $100,000, whereas the fees for an index fund like the Vanguard 500 ETF with 0.04% fees would only be $2,000, saving $98,000 in fees.

Outlines

00:00

📈 Introduction to Mutual Funds and Index Funds

Willis, a chartered accountant with 7 years of industry experience and 9 years of study in accounting and finance, introduces the topic of mutual funds and index funds. He explains the concept of individual shares and how they are sold by companies to raise capital. Shares' prices are determined by supply and demand, and owning a share means owning a small part of the company's assets and profits, including dividends. However, investing in individual shares can be risky due to the potential decline in the company's performance. Mutual funds and index funds are introduced as a way to mitigate this risk by providing diversification. Mutual funds are investment programs funded by shareholders, professionally managed, and include a mix of stocks, bonds, and other securities. They are popular, with 52% of US households owning shares in mutual funds, a significant increase from 5.7% in 1980. The benefits of mutual funds include professional management, diversification, potential for higher returns, and customization based on risk tolerance and investment types. However, they come with significant fees, averaging 2.81% per year, which can substantially reduce returns.

05:03

💹 Understanding Index Funds and Their Advantages

An index fund is a type of investment fund that tracks a benchmark index, such as the S&P 500 or NASDAQ 100. It provides a diversified portfolio by investing in all the companies that make up the chosen index. This reduces the risk compared to investing in individual stocks. Vanguard, founded by John Bogle in 1975, is a prominent provider of index funds, with the Vanguard 500 ETF being one of the most popular, tracking the S&P 500 Index. The key difference between mutual funds and index funds is that mutual funds are actively managed by professionals, while index funds are passively managed, tracking a specific index. This passivity leads to lower fees, typically around 0.1% per year, with some funds having even lower or no fees. The lower fees can significantly impact long-term returns, as illustrated by a comparison showing a $98,000 savings over 30 years when investing in an index fund versus a mutual fund with higher fees. Index funds offer diversification, lower fees, and the potential for higher long-term returns, but they provide less customization and control over the investment portfolio compared to mutual funds.

Keywords

💡Mutual Fund

A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other securities, which is managed by an investment company. Investors in mutual funds pool their money together to purchase these portfolios, which are professionally managed to meet specific investment objectives. In the video, the speaker discusses mutual funds as a means to diversify investments and potentially achieve higher returns than investing in individual stocks, while also highlighting the issue of fees associated with their management.

💡Index Fund

An index fund is a type of investment fund with a portfolio constructed to match or track the components of a financial market index, such as the S&P 500. Unlike actively managed funds, index funds are passively managed, meaning they aim to replicate the performance of the index rather than outperform it. The video emphasizes index funds as a low-cost, diversified investment option that can provide consistent returns and are managed with lower fees compared to mutual funds.

💡IPO (Initial Public Offering)

An IPO refers to the process by which a private company goes public by offering its shares for sale to the general public for the first time. This is a significant event in the life of a company as it allows it to raise capital by selling ownership stakes to investors. In the context of the video, the IPO is mentioned to explain the origin of shares that can be bought and sold on the stock market, which are then included in mutual and index funds.

💡Diversification

Diversification is an investment strategy that involves spreading investments across various financial instruments, industries, and other categories to optimize returns and reduce the risk of loss. The video underscores the importance of diversification in mutual and index funds, explaining how it helps to mitigate the risk associated with investing in individual stocks by spreading investments across a wider range of assets.

💡Portfolio

A portfolio in the context of investing refers to a collection of financial assets such as stocks, bonds, and cash equivalents held by an investor. The video discusses how mutual and index funds allow investors to build a diversified portfolio, which can include a mix of different types of securities, managed either actively or passively depending on the fund type.

💡Investment Manager

An investment manager is a professional who oversees and directs investment portfolios for clients. In the case of mutual funds, the investment manager is actively involved in buying and selling securities to achieve the fund's objectives. The video contrasts this with index funds, which are passively managed and do not require the same level of active management, thus reducing fees.

💡Fees

Fees in the context of investing refer to the charges levied on investors for managing their investments. The video discusses the fees associated with mutual funds, which are typically higher due to active management, and compares them with the lower fees of index funds, which are passively managed. It illustrates how these fees can significantly impact an investor's returns over time.

💡Risk Tolerance

Risk tolerance refers to an investor's willingness to take on risk with the expectation of greater returns. The video mentions that mutual funds can be customized to suit an investor's risk tolerance, allowing them to choose the types of securities and the level of risk associated with their investments.

💡Vanguard

Vanguard is a prominent investment management company known for its low-cost index funds. The video highlights Vanguard's role in promoting index funds and its founder, John Bogle, who sought to offer investment options with lower fees to maximize investor returns. The Vanguard 500 ETF is mentioned as a popular index fund that tracks the S&P 500 Index.

💡ETF (Exchange-Traded Fund)

An ETF is a type of investment fund and exchange-traded product that holds assets such as stocks, bonds, or commodities, and is traded on stock exchanges much like individual stocks. The video specifically mentions the Vanguard 500 ETF, an index fund that tracks the performance of the S&P 500 Index, as an example of a low-cost, diversified investment option.

Highlights

Mutual funds and index funds are two investment options discussed by Willis, a chartered accountant with 7 years of industry experience.

An individual share represents a small percentage of a company's assets and profits, and entitles the owner to dividends.

Owning shares in a single company can be risky due to the potential decline in the company's performance.

Mutual funds and index funds are created to mitigate the risks associated with holding individual shares.

Mutual funds are investment programs funded by shareholders and professionally managed, offering diversification.

In 2023, 52% of US households own shares in mutual funds, indicating their popularity.

Mutual funds are professionally managed, reducing the need for individual stock and bond selection.

Diversification in mutual funds spreads investment across various assets, reducing the risk of significant portfolio decline.

Mutual funds offer the potential for higher returns compared to individual stocks due to diversification.

Investors can customize their mutual fund investments to suit their risk tolerance and investment types.

Mutual funds come with significant fees, averaging 2.81% per year, which can impact investment returns.

Index funds track a benchmark index, such as the S&P 500, providing a diversified portfolio with lower management fees.

Vanguard, founded by John Bogle, is a prominent provider of index funds, with assets under management exceeding $9.3 trillion.

Index funds are passively managed, aiming to match the performance of the chosen index, which can lead to lower fees and higher long-term returns.

The key difference between mutual and index funds is active versus passive management, with index funds typically having lower fees.

Index funds offer less customization but still provide diversification across an entire index, managing risk through this approach.

Investing in an index fund like the Vanguard 500 ETF can save significant fees over a 30-year period compared to a mutual fund.

Transcripts

mutual fund or Index Fund which one's

right for you good question welcome back

to the channel if you're new here my

name is Willis I'm a chared accountant

I've been working in the industry now

for 7 years and I've been studying all

things accounting personal finance and

money related for the past 9 years in

this video we're going to be talking

about the difference between mutual

funds and index funds and hopefully by

the end of this video you will have

established which one if either is right

for you and your Investment Portfolio so

to really understand what a mutual fund

is and an index fund first we need to go

back and understand what an actual

individual share is when a company wants

to raise funds for future expansion or

operational needs they will often IPO or

float on the stock market what this

means is they sell some of their shares

to the public for a certain price to

raise capital for their business when

Shares are floated on the stock market

this means anyone can buy them the price

of the shares will be driven by supply

and demand if there's a large supply of

shares for this particular company then

the price will likely be lower however

if the demand exceeds the supply then

the price per share will often be much

higher owning one single share of a

company means that you own a very very

small percentage of all the assets and

profits that this company generates this

also entitles you to a small amount of

the dividends that the company pays out

usually on an annual or quarterly basis

when you own shares in the company

you're then able to sell those shares on

the open market to any willing buyer at

whatever the prevailing price is on that

particular day this does however assume

that there is another willing buyer to

purchase the shares at that price from

you if you think about some of the

biggest companies in the world such as

Apple Google Facebook and Amazon chances

are they will always be willing buyers

to purchase those shares from you

however owning shares in one single

company can be risky this is because

you're effectively putting all your eggs

in one basket and if the performance of

the company that you hold shares in

declines then so does the value of your

entire portfolio there are also many

factors outside of your control that can

cause the value of the shares you hold

to decline given the risk involved with

holding individual shares in order to

somewhat mitigate against this risk this

is why mutual funds and index funds

exist so first of all we're going to be

discussing mutual funds what they are

how they work and whether they may be

right for you mutual funds have been in

use for many decades a mutual fund is an

investment program funded by

shareholders that invests in a

diversified holding mutual funds

typically include investments in stocks

bonds and other Securities and are

professionally managed by an investment

manager many people throughout the world

put their money into mutual funds

through their company's pension plan or

401K this is in the hope that by the

time this individual reaches retirement

age the value of those mutual funds has

increased substantially enough that they

can then afford to retire comfortably in

2023 52% of us households own shares in

the mutual fund and this is growing over

time as only 5.7% of households held

shares in mutual funds back in 1980

according to a recent release by the

Investment Company Institute

approximately 116 million individual

American households have an investment

in a mutual fund note that this is an

individual assessment so one individual

person and not an investment made by a

company this is up from 96.2 million 10

years ago in 2013 the Investment Company

Institute also reported that most of

these individuals are middle class with

2/3 of them earning less than $150,000

per year here so you can see that mutual

funds are one of the key investment

vehicles of choice for most US citizens

so the key benefits of mutual funds are

as follows number one they are

professionally managed which cuts down

the administration time on your end this

is because you no longer need to pick

out individual stocks and bonds and

securities to be held within your fund

because this is all managed by a

professional investment manager on your

behalf number two a mutual fund offers a

diversified portfolio what this

essentially means is that you're

spreading out your investment across a

variety of assets and securities so you

avoid putting all your proverbial eggs

into one basket so if one or two of the

assets within your portfolio decline in

value this shouldn't cause the overall

value of your portfolio to decline

substantially because of diversification

benefit number three potential for

higher returns compared with investing

in individual stocks again this all

comes down to diversification for

example if through your mutual fund

you're invested in a certain index and

that index increases then you'll make

some gains however if you're invested in

one individual company within that index

that decreased in value then your

portfolio would have seen a reduction in

value and you would have lost money

benefit number four is customization you

can customize your investments in mutual

funds to suit your risk tolerance and

types of Investments this means you can

pick individual different types of

Securities that you want to invest in

such as local stocks overseas stocks

bonds precious metals Etc you can also

customize your Investments to meet your

risk tolerance so if you are further on

in life you may want to invest in

Securities and assets that are more

secure than someone who may be a lot

earlier in their working career however

the major problem with mutual funds as

has been well documented over the last

few years is the fees involved the

reason for this is because of the fact

that mutual funds are professionally

managed and the individuals managing

those funds do require payment a recent

study showed the average fees for mutual

fund Investments are 2.81% per year this

is very significant and can add up

substantially over the years when you

think about making a 7 to 10% return

annually on your mutual fund Investments

a 2.81% fee actually represents a 40.1%

fee on your return as such these fees

can be huge so hopefully that gives you

a brief understanding of what mutual

funds are and how they operate and

whether they may or may not be for you

now let's spend a few minutes talking

about index funds an index fund is also

very different to investing in an

individual stock an index fund is

essentially an investment fund that

follows a benchmark index such as the

S&P 500 or the NASDAQ 100 when you put

money into an index fund your cash is

then used to invest in all the companies

that make up that chosen index which

again gives you a more diverse portfolio

than if you were just investing in

individual stocks and as we discussed

earlier diversification helps to spread

your risk reducing the likelihood that

you could suffer catastrophic loss

should the share price of your chosen

individual stocks decrease substantially

potentially the most popular investment

advisor organization that promotes index

funds is Vanguard Vanguard was founded

in 1975 by a man called John Bogle John

Bogle saw the fees involved in mutual

funds and saw how they were eating away

investors returns over their lifetime as

such he decided to set up Vanguard which

now has assets under management of over

9.3 trillion dollar yes that's trillion

with a t Vanguard offers a variety of

index funds today perhaps the most most

popular one is the Vanguard 500 ETF

which is an index fund that tracks the

performance of the S&P 500 Index and

essentially the purpose of this Index

Fund is to match the performance of The

Chosen index so if the Vanguard 500 ETF

is your chosen investment vehicle then

an increase in the S&P 500 Index which

represents the 500 largest companies in

the US would cause your investment in

the Vanguard 500 ETF to increase by a

similar proportion Vanguard and other

providers also offer index funds across

various different Market niches for

example the the Vanguard dividend stocks

which focuses on holding shares in

companies that pay higher than average

dividends or there's the technology fund

which focuses on holding shares in

companies in the technology sector as we

mentioned index funds are inherently

Diversified as they're tracking a whole

index rather than an individual bunch of

companies and what this means is if your

index was tracking for example the S&P

500 the top companies within this index

would constantly be changing the

absolute best companies would stick

around in the index for a long time

however the worst performing companies

would fall out of the bottom of the

index and replaced by the next best

company at no cost to you the key

difference between a mutual fund and an

index fund is the fact that a mutual

fund is actively managed by a

professional investment manager whereas

an index fund is passively managed which

means there's no professional investment

manager to manage your investment for

you the key reason for this is because

Index Fund is tracking a specific index

rather than a bucket of individual

different Securities chosen by a

professional manager now this may sound

like a downside for index funds on the

face of it however research has shown

that less than 10% of professional

investment managers actually

consistently beat the market over the

long term this suggests that you may

actually be better investing in a

passively managed Index Fund because

over the long term the returns could

actually be higher and the fees

substantially lower this is because with

a mutual fund you're being charged a

flat management fee you're being charge

a transaction fee every time the

investment manager makes a trade on your

behalf there may also be capital gains

tax consequences every time the

investment manager sells one of your

securities on your behalf and the most

attractive part about index funds

because they are passively managed the

fees are much lower generally in index

funds have a fee of around 0.1% perom

some even have 0% completely meaning

that there is absolutely zero fees on

your investment return for that year

going back to the Vanguard 500 ETF as

one of the most popular index funds out

there this fund has an annual fee of

0.04% perom this means that if you were

to achieve an annual return of 7% on

your investment within this Index Fund

only

0.57% of your return would be going to

fees as you can see this is clearly

significantly better than the 40.1% we

were discussing earlier under mutual

funds just using a simple compound fees

calculator found on the internet we can

see that with a starting investment of

$1,000 over a 30-year period with $200

invested monthly at a relatively

conservative 7% per anom return with

2.81% fees the fees effect over that

30-year period would be $100,000 what

this essentially means is that under

this criteria investing in this way

would have cost you $100,000 of fees

over a 30-year period if we instead

change the fees within this calculator

to 0.04% as is the case with the

Vanguard 500 ETF as an example the fee

is only $2,000 over the 30-year period

so you can see by investing in this

Index Fund instead of the mutual fund

this saves you a total of

$98,000 over a 30-year period in fees so

that's a brief overview of mutual funds

and index funds to summarize we can see

that mutual funds offer Professional

Management potential higher returns than

individual stocks more variety of

investment options than individual

stocks and a level of customization on

the other side index fans offer passive

management rather than active management

which reduces fees and potentially

achieves a higher return anyway

consistent performance with an index f

is likely given that it's tracking the

overall performance of an entire index

rather than a specific bucket of

Securities however index funds do offer

less customization and less of an

ability to alter the risk tolerance

however they do still offer

diversification across an entire index

and so your risk can be managed in this

way I hope you enjoyed this video and

got some value out of it if you did

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