If you're new to investing, an index mutual fund is an easy way to get diversification at a low cost. But a survey by MFS Investment Management, a Boston-based asset management firm, shows that not all investors know the correct definition of an index fund or know what they're taking on when they buy the funds.
Even among young people who have already accumulated a lot of wealth — the survey was limited to investors with $100,000 and more of investable assets outside retirement accounts — there is confusion.
"There's clearly a need for investor education," said William Finnegan, head of global retail marketing for MFS.
Understand risk: One point of confusion had to do with risk.
When listing the major reasons for owning index funds, 45 percent of Gen Y investors in the survey (defined as those younger than 34) selected "minimal risk" as one of their answers.
Finnegan worries that investors may think index funds are less prone to losing money than the alternative option, an actively managed mutual fund. "But that's not true," he said.
An index fund will own a basket of stocks or bonds similar to that of a market benchmark, such as the Standard & Poor's 500 stock index. If the market goes down, the index fund will decline as well.
Case in point: In 2008, when the S&P 500 fell a total of 37 percent, the Vanguard 500 Index fund, which tracks the U.S. large-stock index, dropped the same amount.
"With an index fund, you own whatever the market is that you're investing in," said Fran Kinniry, a principal in the investment strategy group at Vanguard, which launched the first index-tracking mutual fund in 1975. If that market declines, so too will the fund tracking it.
But Kinniry also points out that the risk of losing significantly more than the market is minimal. The same is not true of actively managed funds.
These funds can suffer bigger losses (or bigger gains) because an investment manager is deciding which stocks and bonds to buy or sell.
"You take on the risk that the manager makes the right decisions," Kinniry said.
Managers don't always get it right: Through Feb. 28, just 51 percent of actively managed U.S. stock funds had a one-year return that beat their benchmark, according to Morningstar.
The numbers weren't better for longer periods. During the past 10 years, only 41 percent of funds delivered a benchmark-beating annualized return.
Know what you own: So, do young investors understand the differences in risk? That's hard to tell. Many people seem to spread their bets. In the MFS survey, nearly two-thirds of investors, regardless of age, who own index funds also own actively managed funds.
And not everyone can correctly identify what an index fund is. In fact, 41 percent of all investors in the MFS survey said they had no idea what the definition of an index fund is.
Some investors may have been thrown off by the wording of the question, which used the term "passive investments" to describe index funds.
Index funds are a type of passive investment strategy because the funds follow a benchmark, rather than owning investments that are hand-picked by a manager.
Still, Finnegan argues that investors, young and old, should study the pros and cons of actively managed and index funds. There are risks to both types of funds.
"You should know what they are," he said, "before you buy."