When you invest in an actively managed mutual fund, you are investing in expertise. In exchange for an industry average yearly fee of 1.24% of the money you invest, you get a fund manager and a group of analysts who spend their days trying to pick the investments that will earn you the most money possible. So, how do they do?
Unfortunately, not too well. The Washington Post reported earlier this year that a study by S&P Dow Jones Indices looked at 2,862 actively managed domestic stock mutual funds and found that only two funds in the entire group stayed in the top quarter of the group for five years in a row. Yes, just two measly funds.
The entire point of giving away a percentage of your investment to a mutual fund manager is so that your manager can do better than a typical stock index, like the S&P 500 or the Russell 2000. The truth is, however, that many funds don’t consistently beat the indices, which means you may have a better chance of earning more simply by purchasing the exact same stocks in a popular index instead of relying on a professional mutual fund manager.
Rise of the Index Fund
This is the exact thinking that led to the creation of indexed mutual funds, which are – you guessed it – mutual funds established to shadow specific indexes. In 1975, Vanguard created the first indexed mutual fund, the Vanguard 500, which shadows the S&P 500. This is still one of the most popular mutual funds in the financial industry.
Benefits of an Index Fund
Supporters of indexed mutual funds believe that, over the long run, they generate higher returns than the majority of actively managed mutual funds, which tend to rise and fall as different investment styles are rewarded and punished by the market.
Supporters also point to additional benefits.
Lower Expense Ratios
Indexed funds are not actively managed. That means you don’t have to pay for an expensive manager and team of analysts. Vanguard claims that its average expense ratio is just 0.18%. Compare that to the industry average of 1.24%. In other words, if you had $100,000 to invest in a mutual fund, you’d only pay $180 a year in fees at a 0.18% expense ratio. At a 1.24% expense ratio, you’d pay $1,240 in fees each year. That’s money that could stay in your retirement account, generating growth over decades for you!
Fewer Trade Fees
Additionally, it costs money for managers to trade stocks and bonds. They have to pay brokers and traders and cover bid-ask spreads. All of these fees continually chip away at your earning potential. Index funds almost never make trades unless the indexes themselves drop a company from their lists and add another. Even if your actively managed mutual fund out-performed an index fund, you might still come out behind just due to the annual fees and trading costs.
Capital Gains Taxes
Lastly, whenever you sell a stock and earn a profit this is considered a capital gain and is subject to capital gains tax. You’ll likely pay an even higher tax rate if you sell your stocks within the same year of purchase. Mutual fund managers actively trade stocks all the time, generating a lot of short-term capital gains for their clients and racking up high tax responsibilities. Those who have their mutual funds in an IRA or 401(k) don’t have to worry about capital gains taxes, but others who invest in mutual funds outside of their retirement account could see their profits greatly reduced by tax obligations.
Is an Index Fund the Way to Go?
It may seem like investing in an indexed mutual fund is a no brainer, but every investor has their own goals and risk tolerance. Active mutual fund managers are able to move fund assets into cash to weather storms or to sell or buy quickly when important financial news breaks. Those in indexed funds just have to ride out the waves. Also, every year some actively managed mutual funds beat the indexes. A few funds even manage to do this on a consistent basis. The challenge is to find an actively managed mutual fund that can beat the indexes in the longer term and can earn enough returns to pay for their extra fees and taxes.
Women who want to take an active hand in managing their investment and retirement accounts and who enjoy researching funds may be better off trying to find a high-performing managed mutual fund.
Women who don’t have the time to fret over fees, analyze 10-year vs. 5-year vs. lifetime performance of mutual funds, or study up on fund managers, may prefer to put their money into low-cost index funds and let them rise and fall with the market.
Here’s a great article we wrote on picking the right mutual fund.
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Always remember, past performance is no guarantee of future results, and investing involves risks.