Index funds or actively managed mutual funds? What is better for your buck

By: Jimmy Fuentes

 The S&P 500 as of 2012

The S&P 500 as of 2012

 

The much-heated debate (there isn't a debate, I just wanted to write this) on what makes a good investment for those who don't have time to read balance sheets and income statements of individual companies and make a judgment on whether or not to place your money (like I do, God I'm such a loser.) An actively managed mutual fund or an index fund that mirrors/tracks certain indices can be the better solution for you. However, which fund works in your favor and how can you get the most out of your money in the long run?

What is a mutual fund? What is an index fund?

First, let's start off with the definition of each fund to have a better understanding of how they operate/work.

  • Mutual fund: An investment program funded by shareholders that trade in diversified holdings and is professionally managed... "professionally managed"
  • Index fund: A type of mutual fund with a portfolio constructed to match or track the components of a market index (the NASDAQ, S&P, Dow Jones, etc.) 

Pretty self-explanatory here, the mutual fund is professionally managed, while an index fund tracks certain market indices using algorithms and cool math that not even investors understand but think it's worth placing our cash in. Whatever the market gains or loses that year reflects upon your own personal portfolio. The average return of the markets are about 8 - 10% in the long run, so the money manager must get a return that is greater than that, right? The answer: sometimes yes and sometimes no, but a majority of the time, no

Mutual funds have fees, fees, and uh, oh, also, fees.

Since the mutual fund is diversified without you having to do any work and is done so by a money manager, you'll obviously have to pay up for the services and how hard your money manager has worked to give you "large returns on your portfolio." The average fee for an actively managed mutual fund is 1%. The percentage is taken out usually by the end of the year and the fund will always charge you that 1% for the many years that follow, even if you have a loss in your portfolio (talk about a double whammy.) Over time, this can eat up a lot of your money, essentially, as your money grows over time, so does the amount the mutual fund takes from your portfolio, even though it's still at a 1% rate. Over 40 years, the fees can cost anywhere from $100,000 - 500,000, yikes. As for an index fund, where the allocation of your money is done through a computer and not a human, you end up paying a smaller fee, about 0.16% or less. 

1%? That's not too bad you might think. Wait, it might just get better from here (it doesn't.) You'll also be charged an expense ratio or the money that goes directly to your money manager, marketing, and paying the man who created the mutual fund. Which can go from 1 - 1.5%. Again, the 0.16% of what you pay for the index fund already covers the marketing and just the marketing for the fund since it's all algorithms. 

Lastly, commission, you might be asked by the broker/brokerage who owns the mutual fund to cough up some more cash. They might persuade you by saying you'll receive better returns on your money, don't trust it. As for an index fund, whatever the market gives you is what you get at the end of the day. No more and no less. 

Mutual funds, while managed by "professionals" don't beat average market returns... 

Here's the part that shocks everyone the most. *clears throat* 95% of all mutual funds FAIL to beat the market after three years. You might say "but Jimmy, I own a mutual fund and it's been giving me great returns these past two years and I think next year I'll still get great returns." You can't make that sort of judgment of a fund that has been alive for 2 years, (not unless you're a wizard who can see the future) we need an entire track record of how it has performed in the past 10 years, 20 years, maybe 30. See how well (or bad) it endured economic hardships, changes in leadership or management if they DO beat the market how consecutively do they beat it? Consistency is key to having a bundle of wealth once you decide to retire.  

My advice, remain in index funds, and if you find the 5% of mutual funds that consecutively beat the market year after year, decade after decade, that is really cheap, please inform me about it ASAP. They're most likely ran by women, historically speaking, hedge funds ran by women tend to outperform funds run by men, it saddens me because 1 in 10 hedge fund managers are girls :( we need more ladies in finance. 

Here are some reads on and about index funds

Unshakeable: Your Financial Freedom Playbook
I Will Teach You To Be Rich
The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns