Should I Invest in Index Funds or Managed Mutual Funds?

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 versus mutual fundsIndex 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). The ratios might not seem like a lot, but compounded over decades, it can make a huge difference.
  • 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.

Do 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. You probably do as well. So, take a real life look at an index fund versus a comparable mutual fund within your 401K plan.

Look at:

  1. the annual performance
  2. the annual expense ratio
  3. the results over 1, 3, 5, and 10 years.

Google Finance is a great tool to do this. Just look up one simple and add another in the performance chart to compare.

Also, keep in mind that active mutual fund managers change. And, a few good years of strong performance can be counter-balanced by a few bad years of low performance in the future. The law of averages catch up with almost every fund manager.

The Results

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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