Okay, so I’m a regular at the Motley Fool. Their strategy for buying mutual funds is to not buy mutual funds, but buy indexed funds instead. However, I am still unable to fathom the difference between the two. The closest I got was here, where it states:
Which doesn’t help me all that much.
Is there anybody who can give me a clear definition of the difference between the two? And if you can make fun of me (not insult, but make fun) at the same time, you defintely get bonus points.
Skott
Disclaimer - I know nothing.
An index fund is fixed to a particular index, like the Dow Jones Industrials or the S&P 500. It will buy and sell stocks to keep an accurate representation of the averages as they are calculated. You will always do exactly as well as the index. It’s a form of mutual fund, but it’s goal is to mirror the index.
Other mutual funds are trying to manage their assets using different priorities.
It’s not your problem, it’s Motley’s definition.
An index fund is a category of mutual fund, not a different type entirely.
Here’s the 101 lesson. A mutual fund is a company that pools its members’ money to buy shares of other companies. Instead of your pitiful $500 going to buy a couple of shares of one stock, thousands of you get together and pool your money to buy some of this stock, some of that, and some of the other.
Mutual funds come in a variety of categories. Growth (the fund is looking for shares that will increase in value), income (companies that pay dividends), funds that invest only in European companies, only in the medical industry, etc. Obviously, they look for the best performers in each category.
One of the categories is an index – the mutual fund buys into all companies that fit a certain group – say, all 30 companies on the Dow Jones list of industrial stocks, and they try to weight their purchases to reflect the actual clout of the companies. As a result, they more nearly reflect what the actual industry is doing, not just the performance of a few companies.
That’s the ten cent explanation. I’m sure someone will come along and pick it to bits.
I, too, must add the disclaimer that I don’t really know much about this field. 
kunilou is quite right, so far as I’m aware. Index funds are a type of mutual fund.
“Managed” mutual funds have a human picking what stocks to buy and sell with the fund’s money - a sort of active control. The manager is often touted as an expert, and this is his or her full-time job.
Index funds, as I understand it, are pretty much automated. They only buy stocks that appear in an index, say the S&P 500, and choose the relative amounts by some formulaic method. Once the formula is set, there is no decision-making necessary, and the performance of the fund is essentially guaranteed to match that of the index.
Since there’s no high-priced expert working 80 hours a week calling the shots, index funds tend to be cheaper than managed funds. I’ve been led to believe that managed funds, while they often do perform better than index funds, can have trouble doing “better enough” to justify their much higher costs.
I’m sure somebody can correct me if I’ve got any of that wrong…
Would it be accurate to say that a “straight” mutual fund is a bunch of people pooling their money and investing in a single company, while an indexed mutual fund is a bunch of people pooling their money and investing in multiple companies?
No. A “straight” mutual fund is a bunch of people pooling their money to invest in a bunch of companies chosen by an active manager, whereas an “index” fund is a bunch of people pooling their money to invest in a bunch of companies chosen by an index creator (whether that index creator be Dow Jones, Standard and Poors, or whoever).
An investor gets the benefits of multiple-company diversification in either case; the difference is whether the choice of companies comes from a manager or from the creator of the index.
The reason the Motley Fool recommends index investing is that, as brad_d mentioned, these funds are not actively managed. The fund just buys whatever stocks are in the index. For example, IIRC, the S&P 500 represents the 500 largest capitalized companies that trade in the US. So index funds don’t have to pay a fund manager and a bunch of research assistants, so their fees are generally low.
Sure, you think, but actively managed funds can be selective and just buy the big winners and make sure to avoid the dogs, so they should be able to produce much higher returns than an index fund, right? Wrong. Something like 80% of all mutual funds underperform the S&P every year.
The other way to buy into the S&P is through “Spyders,” which are individual shares (a type of derivative, really) that track the S&P. They trade on one of the exchanges (I forget which one) under the ticker symbol SPY. But you need a broker to buy these.
You don’t really buy a mutual fund. You buy the services of the mutual fund manager. By purchasing shares of a particular fund you are putting your money into the hands of a known manager who has a known track record.
The Motley Fools (David and Tom Gardner) have not been real keen on mutual funds. They’re into purchase of actual stock. They like getting into the day to day adventures of balance sheets and they attend and enjoy stockholder meetings.
For over a decade they have said that if you “must” buy a mutual fund then you should buy the S&P 500 Index.
Index funds were pioneered by John Vogel at Vanguard Group.
Anyway, it’s your money and you shouldn’t be asking for advice about it on a message board. Learn as much as you can about investing on your own and remember that there is only one person in this universe who is really intrested in your financial success. Educate that person!
As always, here are my two favorites to start your homework:
http://www.vanguard.com/
and
http://www.bobbrinker.com/
Take your time and Good Luck!
So an active manager can decide to change the companies invested in at any given time, depending on whether he/she thinks it’s a smart market move, while an indexed will pretty much always remain static… except in rare cases where the index needs to be changed (like the what happened to the Dow Jones recently).
So, using this criteria, I would assume that a fund like the Janus 20 is in indexed fund? Or is the fundemental concept here still escaping me?
Here are the basics of an index fund http://www.indexfunds.com/basics.htm
Probably more than you wanted to know, but a good site all the same.
Janus 20 is an actively managed fund, but it is a perfect example for describing the difference between an actively managed and passively managed (index) funds.
Running Janus 20 is a guy. Scott Schoelzel. He personally selects the 20 to 30 stocks that go into the fund. To do this, he and his analysts examine literally hundreds of companies. They go through the financials, meet with management, visit plants, check out competitors, customers, suppliers, etc. They look for general information on the industry that each company operates in. Then Scott selects the 20-30 companies he likes best and buys them for the fund. That’s “actively” managed.
Now let’s look at an index fund. They usually are named after the index they track, so they’re pretty easy to spot. Let’s say I open up the “manny’s mutual fund company Dow Jones Fund.” Well, if it’s an index fund that mirrors the Dow Jones Industrial Average, I don’t have to do all the work that Scott and his team have to do. All I do is buy the thirty stocks in the Dow in such a way that my fund’s performance will mirror that of the DJIA. When the Dow kicks out one stock and adds another, I do the same. Because I don’t have to pay Scott and his team of analysts, I can charge a lower management fee.
By the way, Janus 20 is what is known as a concentrated fund.
Instead of seeking the diversification of a normal mutual fund (which could have a portfolio of 60, 80 or more stocks) you’re making a bet on the record and reputation of the stock pickers.
Concentrated funds have a lot riding in a small egg-basket, so they can be very volitile.
A bunch of people pooling their money and investing in a single company is what stocks are. When you buy a stock, you’re pooling your money with all the other stockholders to invest in that company.
Don’t forget that ALL index funds underperform the index they track, and are usually riskier than a normal mutual fund.
Arjuna34
Okay I think I understand. One or two final question remains for me then: Who determines the stock indexes, such as the S&P 500? Could I come up with my own indexed fund, such as SRNI (Skott’s Really Neat Index) 2450?
BTW, thanks for the link, bio-brat. Very helpful information. And thanks too, manhattan, for all your help.
The amount that index funds underperform their index is negligible, particularly when compared to how much the average traditional mutual fund underperforms. And, depending on the index, I suppose an index fund could be more volatile, but the S&P index fund contains the 500 largest-capitalized companies in the U.S. A stock fund can’t get much safer than that.
It’s worth noting that all indexed funds are NOT alike.
With the exception of the DJIA most indices used for benchmarking index funds have their constituent stocks reviewed regularly. Most of the companies that run indices publish a rule book, so fund managers reading these ahead of an index review will be able to guess which stocks are going in and out at the next review. It is noticeable that in the run up to a review those stocks which are thought to be going in will experience a squeeze and the laws of supply and demand force the price up temporarily. Canny managers will be exploiting the full leeway the local financial regulators allow them to get in and out of the stocks thought to be admitted / replaced in an index before the rest of the market wakes up. Anybody vaguely clued up in london will be able to tell you pretty accurately weeks in advance what will be going in and out of the FTSE 100. Sadly, many of those who run index funds are not clued up, thus the variance in underperformance of funds tracking the same index.
As to the various opinions put forward about the relative performance of actively managed and indexed funds, well, if as an individual you feel confident in your ability to tell a fund management rocket scientist from a muppet, good for you. Unfortunately i find it ain’t that easy, as each is as good as the other at backing their performance claims with lies, damned lies and statistics.