CC photo by: Bobasonic

Let’s take a look at index funds and compare them to actively managed mutual funds. It’s important to understand the distinction between the two, because you may have the option of both within your employer sponsored retirement plan. In order to truly understand index funds, you need to first take a step backwards and discuss what they are ‘cloning’ - stock market indices.

What is a stock market index?

Stock market indices measure the composite value of a group of stocks. Indices can be chosen through a set of rules or hand selected by committees. One of the more popular indixes is the S&P 500, which is a committee selected group of 500 large cap (market value) stocks, mostly domestic, that are meant to resemble the market as a whole. Another example of a market index is the Russell 2000, which includes 2000 small cap stocks. You’ll also find indexes that measure different sectors of stocks such as international, health care, real estate, REIT’s, and just about any other way you can group stocks.

What is an Index Fund?

Index funds are a type of mutual fund that attempts to mimic the performance of a stock market index. Like a mutual fund, index fund share values are based on the net asset value of all of the stocks they have invested in. Rather than its holdings being regularly bought and sold through managed trades, index funds periodically change investments based on a set of rules or infrequent committee selected changes. A lot of them take the human decision element out completely.

The first index fund was created in 1975 by Vanguard founder John Bogle. Some believe that Bogle’s philosophy was based on the book A Random Walk Down Wall Street by Burton Malkiel, which argued that one cannot consistently outperform the market averages. To this date, Bogle (now retired from Vanguard) and Vanguard remain strong advocates for investing in index funds, and Vanguard is now the second largest mutual fund company in the world.

Why Index Funds?

Proponents of index funds point towards data that shows that they consistently outperform their actively managed mutual fund peers due to the following reasons:

• Usually they have lower management fees (because they aren’t actively managed).
• They trade much less, so turnover ratio is lower. As a result capital gains taxes can be lower.

Comparing index funds to mutual funds often times will make them look favorable. There are mutual fund managers out there whose goal is to meet the market indexes, not consistently outperform them. Because they’re actively managed, their fees are higher and their turnover ratios are higher.  Also, in general, there are some horrible mutual fund managers out there. It makes sense to check their histories before you purchase any of their shares.

A Real Life Comparison

My opinion is that you should take advantage of what is offered to you. Vanguard is my employer’s 401K plan administrator and within my plan I have the option of both index and mutual funds. Let’s take a real life look at an index fund versus a comparable mutual fund within my 401K plan.

Index fund - Vanguard Total International Stock Index (VGTSX): expense ratio = 0.27%, no manager, has outperformed the MSCI EAFE international stock index in four out of the last five years.

Actively managed mutual fund - Artisan International (ARTIX): expense ratio = 1.21%, manager is Mark Yockey who started with the fund in 1995 (good longevity). ARTIX has only outperformed the MSCI EAFE international stock index in two out of the last five years.

The Results: Over the last five years, VGTSX has outperformed ARTIX with a total return of 146% to 100% (with almost 1% lower management fees). This is a significant difference. In this case, being presented with these two funds for international exposure, I would opt for the index fund (VGTSX) every time. However, if I was doing the same comparison within a personal IRA and had other actively managed options to choose from, I would do my research and look to see if I could find an alternate actively managed fund with a lower expense ratio, low turnover, a seasoned manager, and better returns than ARTIX and VGTSX. One needs to look no further than DODFX, which returned 189% over the same period of time, with a team of 9 managers and only a 0.66% expense ratio.

You’ll find a number of investors who invest solely in index funds because they buy into the Bogle rhetoric that index funds are superior in every way in the long run. In many cases, they are. However, there are always exceptions and you should do your homework.

If you have the option of choosing between the two, take a look at the results of the mutual fund managers available to you. This post takes a look at some of the things you should look for in a mutual fund. When presented with limited options, I have opted for index funds. When presented with unlimited options, I never have.

If you found this article helpful, subscribe to my free RSS feed, or sign up for free email updates! You may also find the following articles of interest:

The Complete Guide to Choosing Between a Traditional 401K and Roth 401K

Free Google Docs and Excel Personal Budget Planner Spreadsheets!