Index Funds vs Mutual Funds – What’s the Smartest Way to Invest Your Money?
The debate between mutual fund investing — actively managed fund — and index fund investing — funds that track broad market indexes — is decades old. According to Vanguard and S&P Dow Jones Indices, the index funds have historically outperformed mutual funds in every investment category since 1871.
If you’re not a savvy investor and you don’t employ financial advisers, there’s no reason you shouldn’t invest in index funds.
The difference between mutual funds and index funds:
Funds can be classified into two categories, mutual funds, and index funds. These terms are used to refer to the primary purpose of the funds.
Definition
A mutual fund is used colloquially to refer to actively managed funds. An active mutual fund is managed by stock pickers with the primary goal of beating the market’s performance.
Active mutual funds are professionally managed by experts who pick bonds or stocks on your behalf. You generally pay annual fees, which can range from 0.5% to 1%. The fund manager has to outperform the market to justify these fees.
On the other hand, Index fund — passive index fund — simply tracks an index such as the S&P 500. It’s similar to ordering from a pre-fix menu in a cafe. You get whatever is on the menu, and sometimes it’s not appetizing, but it’s cheaper than custom order, and it can come as low as 0.2%. The average fees for a passively managed index fund can range from 0.2% to 0.3% annually.
The Great Recession
The stock market has recovered since the Great Recession, but active fund managers — by all measures — haven’t been able to beat it. On the contrary, passive investors have gotten richer. People who bought S&P 500 passively managed fund as early as 2010 are three times richer today.
The notion that actively managed fund can outperform the stock market indexes simply by picking good investment is misleading. Indeed some star managers have — over the course of their careers — crushed the performance of the stock market. But for every manager who beat the market, there are several more managers who didn’t it.
By the Numbers
According to data shared by Morningstar, in 2016 fewer than 20% of large-cap stock funds outperform the market over the 9-year period from 2004 to 2013. The reasons for under performance can be attributed to fees, risk, and volatility. Meanwhile, over 31% of lowest-cost large cap funds beat the market while fewer than 9% of highest-cost large cap stock did so.
The Key Takeaway
The key takeaway is that market-beating performance is harder than simply picking a good investment. For decades, the S&P 500 index has returned, on average, 9% annually. For an actively managed fund to match the return of an unmanaged stock market index, it has to generate an annual return of 9.9%, in large part because of high maintenance fees that eat into returns.
Some actively managed funds will perform well and generate returns that beat the market, but these funds are difficult to pick out. And because fewer than 40% of the actively managed funds will achieve market-beating performance after fees and expenses are taken into consideration, it makes it even harder to ascertain the best performing funds.
Conclusion
In conclusion, index funds that let you invest in a wide range of stocks at a low cost can be an efficient way to invest. However, if you feel confident that you can find good active mutual funds then go ahead and loosen up the purse strings.