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Home » Index Funds, Mutual Funds

Should I Invest in Index Funds or Managed Mutual Funds?

Last updated by on 17 Comments

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. 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. When presented with limited options, I have opted for index funds. I’m starting to see the Bogle way, myself.

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17 Comments »
  • 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: http://20somethingfinance.com/blog/2008/05/13/how-is-a-mutual-funds-share-price-nav-determined/

    • 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.

  • 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.

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