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Should I Invest in Index Funds or Managed Mutual Funds?

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Index Funds Vs Managed Mutual Funds

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 indices 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.

More recently, funds that follow indexes and trade on the stock market – ETF’s – are another passive index investment.

Why Index Funds are Better?

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 of Index Funds versus Managed Mutual Funds

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.

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.

I have personally moved almost entirely to index funds and ETF’s.

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  • Michael says:

    Great post. I’ve listened to Vanguard’s podcasts on index funds where they mention outperforming actively managed funds 70% of the time and speak against chasing the latest fund manager with the highest yield as being the best way to lose your money. I stopped looking into managed funds at that point, but it seems that was a mistake… It seems like if you can find an actively managed fund with a reasonably low expense ratio that consistently outperforms index funds for a substantial period of time, that extra intelligence behind the asset allocation should have a good chance at outperforming the norm. Thanks for the insight.

  • G.E. Miller says:

    Hey Michael. The bottom line is how much are you willing to put into finding managers who are worth investing in? If you’re not willing to do some solid research, then you may be better off with the index funds – and certainly, that’s a bad place to start until your research has been completed.

    • Tristan says:

      Vanguard has done lots of research in this area (as expected), and what they found was that the vast majority of fund managers most certainly do NOT beat the market on a consistent basis. A manager who does beat the market usually only does for about 5 years or so, then has a stretch of another 5-10 years or even longer during which they underperform the market. They have short hot streaks with long cold streaks. I find the following statement to be ever true with each passing day: “There are only 2 types of investors: those who don’t know how the market will perform, and those who don’t know that they don’t know”. Now I’m not saying there are no managers out there whatsoever who beat the market more consistently, but they’re incredibly rare and not easily found. I’m being a little facetious, but you’re more likely to find a leprachaun with a pot of gold.

      For the great majority of investors it’s just best to buy index funds and know you’re getting your fair share of the market 100% of the time, rather than rely on the skill of fund managers, most of whom do not outperform the market regularly enough to make it worthwhile to begin with.

  • Larry says:

    It is my understanding that, if I put X dollars in an indexed mutual fund, the number of shares of stock I hold via the mutual fund will not change (after ajusting for splits) unless I put more money in or take money out.

    I know that the situation with a managed fund is different. If the market crashes, and I want to keep my head and stand pat, the fund manager will none the less have to sell shares of stock at depressed prices to cash out the fund-holders who want to get out.

    Can anyone add any insights to this?

  • Cody says:

    Look at past records? Past performance is no indication of future results. Actively managed funds that consistently outperform the market will increase in demand, therefore also increasing the price. The increased price will reduce the future returns to those that buy in at that higher price.

  • G.E. Miller says:

    @ Cody – Your comment reflects a common misconception. Please check out my post on how mutual fund NAV’s (prices) are determined. Market demand for a fund has no effect on its price. Please see this post:

    • MattAZ says:

      To piggyback off this, it’s not necessarily an effect on the NAV of the fund, but the impact of what’s called asset bloat. As growth in a fund continues, the ability to maintain consistency in the strategy gets harder over time. The ability to build and wind down positions in the portfolio become more difficult. This often leads to underperformance.

      Case and point: Fidelity Magellan (FMAGX).

      There are managers that can have large size and stave off asset bloat by staying in liquid parts of the market (eg: investment grade fixed income) and use more complex derivative structures to gain exposure.

      Case and point: PIMCO Total Return (PTTRX).

  • Daddy Paul says:

    Index funds beat 80 percent of all funds. Makes it an easy choice in a 401K.

  • Sam_UAE says:

    Gentlemen, I have few Questions; Can you please explain (in details) what is an index fund? (in Bloomberg, it says index funds are priced at the end of each tarding session, Is it tradable funds or not? Wha i understand is mutual funds are none tradable funds and ETFs are tradable funds. Am I right?

  • Shawn says:

    Why would the turnover ratio matter in a tax friendly account like a roth or 401k?

  • Natalie says:

    My employer offers a very limited number of options for my 401k funds. However, I’m a big fan of the S&P 400 midcap fund and I have most of my funds there. I’ve been very happy with my choice, it’s almost no-brainer investment.

  • James says:

    Excellent article. You have answered what I’ve been researching.

  • Matt says:

    This article is very inaccurate as of January 2014, which is the last time it was updated.

      • GSS says:

        So to you use your example in making the case of passive international over active management. To update in July 2015 – ARTIX vs. VGSTX since 2008, the last 6 years, the active manager, ARTIX has outpaced VGSTX – significantly, in 5 of the last 6 years with insignificantly less drawdown, so the investor stays invested throughout in order to participate in the gains (see 2011 and 2014).

        ARTIX +39.77
        VGSTX +36.73
        ARTIX +5.91
        VGSTX +11.12
        ARTIX -7.26
        VGSTX -14.56
        ARTIX +25.39
        VGSTX +18.14
        ARTIX +25.18
        VGSTX +15.04
        ARTIX -0.94
        VGSTX -4.24

        The only “winning” year passive has had was 2010 – and these are pulled right off of Morningstar, so includes net of fees. And if I were to extend for 10 years, to include going back to 2005 – ARTIX has outperformed 7 of the last 10 years, and even the “under-performance” of the 2 years it was short, marginal – see below.

        ARTIX -46.96
        VGSTX -44.10
        ARTIX 19.73
        VGSTX 15.57
        ARTIX 25.56
        VGSTX 26.64
        ARTIX 16.27
        VGSTX 15.57

        And before you pull the “taxes” card that indexing is superior, again, public information on Morningstar – here is the “investor” return to account for taxes/distributions on the 10 year annualized.

        ARTIX 7.09% annualized for 10 years “Investor Return” on 7.67% “Total Return”
        VGSTX 4.17% annualized for 10 years “Investor Return” on 5.42% “Total Return”

        Hey wait a minute? How did my International index fund from Vangaurd provide me 131 bps less than what the total return is showing? I though my fees of only 22bps was saving me money and I also though it was more tax-effecient?

        I can save you the trouble from trying to talk your way through it. Yes, indexing works for U.S. Large Cap versus the S&P 500, however when it comes to something as broad as international where you have multiple countries, economies, currencies and policies, and index fund just buys it and is subject the changes and shift, as well as the rebalancing. An international active manager can not only be good a security selection, they can also be selective in what countries and economies and currency tailwinds to help returns.

  • Mike says:

    I have a dwindling 401K thru TD Ameritrade.
    My wife and I are 64 & 63. I cannot afford to be losing money at my age, but our account is down about 10% this year.
    I am desperately looking for a relativeley safe place to put a 401K that will see a reasonable return (whatever that is these days).
    Any ideas?

  • Bill says:

    There can be no valid argument for managed mutual funds, or managed accounts for that matter, unless one can simultaneously claim that this fund or this manager can predict the future (by definition, an impossibility). Yes, there will be, not have been, but will be a few who outperform (after fees and expenses) the market–maybe 1 or 2% over a thirty year period–but no one knows in advance who these will be.
    Therefore, lowest cost index funds (unless you can predict the future, have genuine insider information, have enough money to control an entire market, etc.) will make an investor superior to
    almost all funds, managers and media advisors, except the very rare, exceptional ones we cannot predict. Any counter-argument is pure wishful thinking or just basic con. Back testing can prove anything; good advertising convinces that back testing equals “fore testing” (which does not exist). “Research” into funds is virtually useless–in terms of predicting the future, but it sells hope. Correction: the one future number that can be predicted, approximately, is the percent return of assets under management by the funds or advisors. Hedge funds can count on 3 to 5 percent, or more. Be a fund manager, but invest in broad market index funds.

  • Scott says:

    Mutual funds are not a con. No they are not the right choice for everyone. One key thing that you fail to take into account here is volatility. Some people would rather make 1 or 2 percent less and not have the full swings of the stock market. Some people are happy to average 3 – 5 percent annual returns and see even smaller swings than that. I know the conversation is primarily around mutual fund fees, but advisors can also be worth their money by helping people make better decisions based on time frame, purpose of the funds, and many other factors. When a 2008 happens and an index fund falls 50%, causing an average investor who did a little research and decided to invest on their own to panic and pull out of the market, that fee paid to a fund manager or advisor might be worth a lot more than one would think. One should not only look at performance as the end all be all.

  • mark says:

    When I hear things like “index funds out perform 70% of mutual funds factoring in fees,” I always wonder this: are those the 30% of funds that end up coming also the most popular funds that getting recommended the most often by financial advisors? Do people know which funds are better or is it really anyone’s guess?

    In other words, can people smartly choose mutual funds to the point that it doesn’t matter that MOST index funds come out ahead?

  • kent says:

    First and foremost, I work in the financial industry. I just wanted to get that out front so what follows is from experience, not opinion. With that said, let’s get to it.
    There is a place in every financial plan for a diverse group of investments both managed and unmanaged. The real question remains, how much? Comminality between the different index offerings is the largest problem, if they’re all tracking the same index, why are their retuns so different? When and how do they rebalance? And the biggest flaw with index funds is they tend to hold many non-dividend paying companies so you’ll have to sell assets every time you need cash in retirement. This leads to a shrinking asset base meaning less money making money for your later retirement years. A good example is having 100k in index funds and 100k in divided paying mutual funds in two different IRA accounts. Needing 5% for living expenses would cause a sell of 5000 in the index account, leaving you with 95000 left in the market. Taking 5000 from your divided paying mutual fund account, assuming a 3.5% divided return, would mean only having to liquidate 1500 of principle and keeping 98500 in the market, only a true draw down of 1.5% . Now, let’s look at market swings….should the market adjust the value of your accounts by 10% equally before your withdrawl, the index account would now be worth 90000 and your withdrawl percentage would increase to 5.55% to get the 5000 needed where as your mutual fund account would still generate 3500 in divideds because the reduced price of the mutual fund share does not reduce your dividends. So, you still need to pull only 1.67% from your principle to meet your needs. Put simply, if both accounts never make another penny, your indexed funds will run out very fast, say 15 years where your mutual fund account will still be around for over 30. Paying less doesn’t always mean getting ahead or being better off.

    • Matt says:

      Kent, these types of hypothetical scenarios are essentially useless. I also work in investment management. There are many dividend focused index funds that approach the yields of actively managed dividend-oriented strategies. They also are much cheaper. So let’s look at VHDYX which is a dividend-focused index fund that costs 18 bps in expense ratio. Most active managers in the equity dividend space can get 20-40 bps in yield (which do NOT cover the excess expense) and subject the portfolio to more idiosyncratic risk, include more stock selection manager risk, and multiple other effects that actually take hold when markets are functioning. How likely is an active manager to outperform a size, style, and (in the case of VHDYX), quant-sorted market cap portfolios? Not likely over the long term. It’s almost impossible to know on an ex-ante basis. How likely is equity returning 0% every year for 15 years? And indexes still have yield, snice S&P is yielding over 2%, the yield shortfall is lower than you think. Your 3.5% active manager after costs might only yield you 2% in some cases. Total return investing for retirement is the best way of allowing for portfolio-level risk management to help increase wealth. This is why we moved away from the prudent man standard. Investing strictly within an asset class for income does not maximize outcomes for an investor. The most consistently superior method of implementing that is through low-cost index passive and rules-based passive products. At least then you are still managing your portfolio needs and not outsourcing portfolio management to several active parties who may synergistically create risk concentrations or coverage gaps without your knowledge.

      • kent says:

        Please read GSS post as even if an index fund does pay dividends, they are not the answer to retirement. A tool yes, not the last word. My biggest problem is the “one size fits all” mentality of index investing. Oh, and advisors who use them in wrap accounts..


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