What Everybody Ought to Know About Mutual Funds Vs Index Funds

You’ve decided to invest your money to make your money work for you. At the very least, you’re hoping to have your money work better than if you were to deposit into a fixed interest savings account at the bank. One of the best ways to invest your money is by placing it into a fund.

This article will take you on a brief tour of the wonderful world of funds and will give you a clearer picture of what’s best for you and your money.

What Are Mutual Funds?

The first rule in creating an investment portfolio is that of investing in a diversified portfolio. In other words, instead of investing all your money into, say, Walmart stock, you should invest across a range of stocks, bonds, and commodities. This way all your eggs aren’t in one basket, and your portfolio can better weather the ups and downs of the market.

However, creating a diversified portfolio usually requires a large amount of capital and time to create. For those of us with limited amounts of both, the better solution is to invest in a mutual fund.

A mutual fund is managed by an investment manager (aka a fund manager, money manager, financial advisor – the names are interchangeable). This person creates and manages a fund composed of mixed investments, including commodities, securities, and bonds. You, as a client, purchase a small piece of this fund. Any returns the fund makes on its investments are passed on to you, minus the manager’s fee, which usually comes in the form of a percentage of your investment.

There is a wide range of different funds available on the market, corresponding to different “baskets” of investments. Funds differ in terms of the types of bonds they encompass, and some differentiate themselves according to the reputation of the fund manager. For example, certain mutual funds brand themselves as “socially responsible” or environmentally friendly.

A mutual fund is usually actively managed, which means the fund employs a team of analysts whose job it is to pick investments which they believe will beat the stock market as a whole, i.e “beating the market.”

Mutual funds aren’t the only way to go. The next section will explore the mutual fund’s counterpart, index funds.

What Are Index Funds?

Instead of active managers who pick stocks and investment products they think will beat the market, index funds track a market index.

Think of it this way: thousands of individual stocks are traded in national and international markets. Instead of keeping track of all of this movement, an instrument called an “index” keeps track of particular parts of the stock market. There are even indexes that track how the stock market is doing as a whole. A common example is the Standard & Poor’s 500 (S&P 500 index), which is an index which tracks a cross-section of 500 large American companies.

Instead of getting finicky with specific stocks and bonds like a mutual fund does, an index fund will instead pour all of its assets into an entire index. Going back to our Standard & Poor example, the S&P 500 index fund buys all of the stocks in the S&P 500.

Another example is the Vanguard S&P 500 Index Fund. This is an Index Fund which holds stocks in all 500 companies in the S&P 500 and invests in each in proportion to their relative importance on the index. In other words, larger companies get more invested in their stocks. That means that when the market does well, the fund does well.

Index funds don’t need to follow the stock market. They can track any index the fund manager chooses. There are index funds that only track stocks that pay dividends, or stocks that mine a certain commodity (e.g. silver mining stocks). There are funds which track bond indexes.

Again, the key difference between index funds and mutual funds is that index funds are not actively managed funds. There is no ‘stock picker’ who actively selects stocks and tries to beat the market. Instead, index funds are more of a “set it and forget it” sort of system; they are passively managed.

Since these funds don’t need any active management, index funds are often far cheaper than mutual funds, meaning your returns have fewer fees deducted.

An Easy Review: Mutual Fund vs Index Fund

Index Fund Mutual Fund
Objective To match the investment returns of a stock market index (e.g. S&P 500, Dow Jones Industrial Average) To beat the investment returns of a related market index (e.g. chooses large-cap stocks that the manager believes will beat the S&P 500)
Management Style Passively managed. Investment is automated to track the exact holdings of a market index. Actively managed. Analysts and stock pickers choose fund holdings.
Invests in Stocks, bonds and other securities Stocks, bonds, and other securities
Average expense ratio (management fee) * 0.09% 0.82%

*Source: Expense Ratios of Actively Managed and Index Mutual Funds – Equity Funds 2016 data Investment Company Institute

In 2016, the Investment Company Institute compared the annual expense ratios of actively managed stock funds to index funds. It found that actively managed mutual funds carried an average expense ratio of 0.82% of assets (i.e. your fees were 0.82% of what you invested) compared to the index fund average of 0.09%.

But since the aim of mutual funds is to beat the market, the higher fees shouldn’t be a problem. The higher costs yields higher returns…right?

Think again.

In the long term, mutual funds have failed to beat the S&P 500’s average annual return of 9% since 1871. Over the past 15 years, less than 8% of large-cap mutual funds beat the S&P 500.

What’s more, the higher costs mean that even if a mutual fund beats the S&P 500 by 1%, the effective return you’ll get would be 9.16% vs the effective return of 8.89% of an S&P index fund:

Market Return Average Annual Expense Ratio Effective Return (Market return minus expense ratio)
S&P Average Return 9% 0.09% 8.91%
Mutual Fund That Beats S&P by 1% 10% 0.82% 9.18%

Considering that the odds of an actively managed mutual fund beating the market are low, and the odds of a fund continually beating the market are even lower, is paying more really worth a possible increased return of 0.27%?

There are of course outliers, like Anthony Bolton’s Fidelity UK Special Situations Fund. This fund had an annual return of 19.5% for 28 years, beating the S&P 500s 9%. This fund’s success lasted until 2007, soon after which Anthony Bolton was burned in the Chinese market. Extremely successful examples like Anthony Bolton’s funds are few and far between.

Mutual funds tend to generate a more buzz in their heroic quest to beat the market. There is a huge and sophisticated industry behind mutual funds, including Ph.D. fund managers and brilliant computer scientists working on beating the market. Unfortunately for them, history always beats buzz; historically, the majority of funds have failed to beat the average annual return of 9% of the S&P 500.

This fact, coupled with the lower fees of index funds, is why index funds are becoming more and more popular. Actively managed mutual funds may still seem to be sexy and glamorous, and some may even yield very high returns. But if you are looking to invest for long-term projects like retirement, an index fund’s slow and steady returns may be the right investment fund for you.

0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *