• Ethan Lang

Why Index Funds Are Superior To Mutual Funds

Updated: May 5, 2020

Imagine gazing at the crystal blue ocean, while you lie on a blanket of warm sand, sipping from your glass of wine. As you relax, your mind is at a state of ease because you have achieved financial freedom. Sadly, this is merely a dream for most people today because of their inability to obtain a substantial amount of money for a comfortable retirement. Most Americans are hoping to squeeze by on their monthly social security checks, even though this route is nowhere near promising. For one striving to build this lavish lifestyle, he must know what investment option gives him the greatest odds to retire comfortably. As the popularity of the actively-managed mutual fund grows exponentially, it seems like the optimal choice. However, it is usually not the case when compared to index funds. Although both actively-managed mutual funds and index funds are commonly used investment options for retirement, index funds prevail as a more intelligent option for the average investor due to its management style, total fees, and average returns.

Purpose of These Funds

Despite the similarities in these funds, both actively-managed mutual funds and index funds contradict in terms of their purpose. An actively-managed mutual fund is designed for the purpose of attempting to beat the market year after year. To try and outperform the market, mutual funds are handled by a professional fund manager, whose job is to pick stocks that he believes will produce great returns for the investors in his fund. Due to this manager’s constant need to chase higher returns, he will manage the fund actively by searching for the markets undervalued stocks. On the other hand, an index fund is a portfolio constructed for the main purpose of matching the returns of the market, by mimicking certain benchmarks such as the S&P 500, DOW 30, and Russell 2000. These index funds, only mimicking market returns, are managed passively, meaning the constant trading of these stocks and securities rarely occurs. Because these funds are managed differently, the returns on both of these investments vary greatly.

Returns of These Funds

Many people who invest in actively-managed mutual funds believe that their investment returns will consistently beat the market because their money is entrusted to an investment professional. In their defense, who would not believe fund managers and stockbrokers who obtain advanced degrees in finance and utilize the most high-tech trading platforms? In a similar situation, everyone trusts the decisions made by their doctors because of the advanced degrees they have earned, so it seems logical for one to trust his mutual fund manager with his investments Sadly, this is not always the can because one cannot always trust his mutual fund manager. Statistically speaking, 96% of mutual funds fail to outperform the market in any given year. As a result of these statistics, it is difficult to trace how much money mutual funds return since these returns are fully dependent on the fund manager’s ability. All in all, one would not bet on his mutual fund beating the market if the odds are against him ninety-six to four. On the contrary, since the goal of an index fund is to match the market and its benchmarks, it will never fail to keep up with the market returns. Looking back since the 1950’s, the data proves that the market averages a 7% return after inflation if all dividends are reinvested back into the market. With this data in mind, one can assume that if he invests into an index fund, he can assume to return about 7% a year. Although there is a slim chance of a mutual fund beating the market, this possible return is usually hammered down by excessive fees.

Fees of These Funds

Compared to the minuscule fees of index funds, mutual funds contain steep fees both disclosed and hidden. Looking at them from the surface, it seems as if mutual funds contain an average expense ratio of .90%. Sadly, these are only the fees they are required to disclose to the public. Coupled with the disclosed costs, one will find an additional 1.44% average in hidden costs and a cash drag of .83% upon digging deeper. These fees include 12b-1 fees, account fees, shareholder service fees not included in the 12b-1 fees, sales load fees, redemption fees, and purchase fees. Mutual funds tackle on these cost to maximize the pay given back to the owners of the fund. When one thinks they are only paying .90%, they are actually paying a total of 3.17% in fees to the fund manager. In addition to this, if the mutual fund were to lose money in a given year, the investor would still be paying the 3.17% in fees. Whereas for index funds, the fees are very minuscule compared to the high fees of mutual funds. Because index funds do not contain a extensive sum of hidden fees, they only charge about .10% in fees. These index funds generate significantly minimized fees because of the index fund’s low trading frequency. Overall, if one invests in a mutual fund, they are paying over thirty-one times more fees than the individual who investing in an index fund.

Final Thoughts

Index funds triumph as the superior retirement investment option, despite the fact that mutual funds’ popularity has skyrocketed in recent years. Mutual funds, because of their rising favor, have caused individuals to invest in funds that offer excessive risk in fees without the reward. Index funds, on the other hand, not only deliver higher returns on average but also contain significantly lower fees. Given these points, investing in an actively-managed mutual fund, whose returns are lower and fees are higher, becomes nothing more than individual gambling at a casino with the odds stacked against them.