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Mutual funds and index funds are both marketed as easy ways to quickly diversify your portfolio, without the stress of picking individual stocks. They allow you to quickly spread your money across industries and assets, decreasing your overall level of risk. Though there are similarities, you should understand the key differences between these two assets before investing your hard earned money, and find out which of index funds vs. mutual funds will be better in the long run.
High Level – Index Funds vs. Mutual Funds
Both mutual funds and index funds allow you to purchase a fund that owns a plethora of stocks/bonds, but the biggest difference is how they’re managed. Mutual funds are actively managed. What this means is that there is an individual or team who is responsible for selecting which stocks the fund purchases, with the ultimate goal of beating the market. Index funds on the other hand are passively managed. This means they are just trying to mimic the performance of a market index. But which is better? Read on to find out.
Comparing the Two Asset Classes – Index Funds vs. Mutual Funds
Let’s compare the two types of funds across a variety of categories:
Goal
With Mutual Funds, the fund manager is actively managing the stocks in the fund in an attempt to get higher returns than the overall market. This means they are constantly buying and selling stocks at their own discretion in the hope that the overall return will beat the market (i.e. get better than the S&P500 that year).
Index funds on the other hand are mimicking the performance of the index they’re tracking. So if you’ve got an index fund that is tracking the S&P500, the stocks and weighting of the stocks will match that off the S&P500. If the S&P500 goes up 5%, so does the index fund.
Fees
Because an organization is curating and offering these funds, there’s typically a fee associated with owning a fund. This fee is known as the management expense ratio (MER), and is represented as a percentage of the assets under management. Mutual funds tend to have a much higher fee associated.
Due to the active management, mutual funds MERs can range from 0.5%-1.5%. This cost covers the over head from the teams researching, updating, and managing the stocks held. On a $10,000 portfolio, you would be paying ~$100 per year in fees. This may not seem like much, but imagine the compounding effect over 30 years. With an 8% return, $10,000 would turn into $100,630. With a 7% return (paying 1% in MER), it drops to $76,120. Imagine this difference scaled over a $100,000, or a $1,000,000 porfolio – that’s a significant effect.
For index funds, as they are passively managed, the MER typically is in the range of 0.05% to 0.3%. Because there is no research to determine which stocks are in the fund (they just follow the index), the overhead is much lower. With index funds following a common fund (e.g. S&P500), MERs below 0.1% are not uncommon. What this means is that on $10,000 invested, you could be paying less than $10 a year for the use of that fund.
Flexibility
Index funds are mimicking an index. As such, they’re limited in the stocks that they can purchase. If the fund aims to mimic the S&P500, there’s no flexibility to add stocks that aren’t on that index. Mutual funds however, have a lot more flexibility. The fund managers are able to add any stocks that they think will help them improve the return. As such, they have the possibility of increased returns compared to the index. On the other hand, they can also do worse..
Returns
So if mutual funds are so much more expensive, why would anyone ever buy them? Well, the assumption is that by actively managing a portfolio, a fund manager can beat the market. Whereas with index funds, your return will only ever be as good as the market. So by investing in a mutual fund, you can get increased returns compared to an index fund that will only ever give you average returns. But is this actually the case?
Actual Performance
There are some notable examples of fund managers who had great success (think Peter Lynch), but this is few and far between. In fact, “most actively managed mutual funds do worst than their benchmark index, both over the long run and in the vast majority of calendar years” (Source). Over the course of one year, 51.08% of fund managers underperformed the S&P500 – less than half of fund managers (who’s sole job is to beat the index), got increased returns. It gets even worse over the long run (source):
- Over 5 years, only 13.49% of actively managed funds outperformed the S&P500
- Over 10 years, only 8.59% of actively-managed funds outperformed the S&P500
For a mutual fund to be worth it, not only does the fund have to outperform the S&P500, but it has to exceed the performance of the index by its MER (1-2%). As shown above, doing so consistently is exceedingly difficult. Based on the above data, over a ten year period, in more than 9 of 10 cases, you’d be better purchasing an index fund over a mutual fund. If you’re willing to take that 1 in 10 chance, be my guest. But in the battel of index funds vs. mutual funds, I’m sticking with index funds.
Index Funds vs. Mutual Funds – The Clear Winner
Hopefully based on what you’ve read above, the index funds vs. mutual funds fight has been put to rest. If you’re going to be investing in funds, go for index funds. If you need more convincing, I urge you to read The Little Book of Common Sense Investing by John C. Bogle. Now of course, there are other styles of investing, but by and large I think index funds are one of the best. It frees you up to pursue other money-making pursuits, or just live a more simple life.
So if you do own mutual funds, I urge you to move those into index funds – your future self will thank you.