The Difference Between Index Funds and Mutual Funds

Index Funds vs Managed Funds (Mutual Funds)

Today we assess the difference between index funds and mutual funds. The overall investment objective varies greatly between these two types of funds. 

Index funds are actually a type of mutual fund. An index fund is a passively managed that seeks to match a given market index. The Dow Jones or S&P 500 are two of the most common indices of the overall stock market. An S&P 500 index fund is a very common method of investing in the stock market.

Mutual funds are professionally managed investment portfolios. The fund manager will buy and sell stocks quite frequently, leading to higher turnover, higher taxes, and higher expenses than the average passive index fund. Mutual funds are funded primarily by the shareholders (investors) like you and I. Typically, their goal is to generate the highest rate of return annually for the shareholders of the portfolio which is why they do so much buying and selling. This is why they are referred to as actively managed funds. The way these funds are marketed to the public is usually by comparing returns to general stock market indexes such as the Dow Jones or the S&P 500. 

So why is there so much confusion out there about mutual funds vs. index funds?
Although index funds are technically a type of mutual fund, they differ significantly in almost every other way. For the sake of clarity, it helps to divide the entire category of mutual funds into actively managed and passively managed. Therefore,

• Actively managed mutual funds = mutual funds
• Passively managed mutual funds = index funds​

What's the difference between mutual funds & index funds?

Fees and management style.

The typical fees of a mutual fund are in excess of 2%. The typical fees of an index fund are often less than 0.1%. Doesn't sound like much? Well, it is!

Let's look at an example headline from our friends over at NerdWallet:

Millennials have decades to save for retirement, but also decades of exposure to avoidable investment fees. NerdWallet analyzed a variety of scenarios and in one case found that paying just 1% in fees could cost a millennial more than $590,000 in sacrificed returns over 40 years of saving. 
See their full article here

What is even worse is that this only looked at a 1% fee. Compounded over time, the loss of that measly 1% fee is extraordinary as outlined above. Remember, the average active mutual fund fee is well over 2%.

To make matters worse, if you happen to hold an actively managed mutual fund in a taxable brokerage account, you would need to beat the passive fund by 4.3% just to match the return of the passive fund. Why 4.3%? Professor Mark Kritzman of M.I.T. conducted a study reported in The New York Times.

So if your so-called "index beating" mutual fund was held in an taxable brokerage account.

If you held this actively managed fund in a tax-advantaged retirement account, you would still need to generate at least 2% higher returns just to break even with the passive index fund.

Why? Fees.

The average actively managed mutual fund consists of the following fees:

• Expense ratios - used to pay salaries of managers and other associated costs of the investment management company
• 12B1 Fees - marketing expenses; approximately 60% of actively managed funds have 12B1 fees
• Trading Costs - depends on how "active" the fund is; it is determined by how frequently it trades its' investments in a given year---this is known as the turnover ratio
• Sales Commissions - fund "loads"
  • ​A load is typically charged on entry or exit in and out of the fund. Some funds have loads of 5 or 6%. That's huge. If your investments grew to a $1 million over time--which is very reasonable given a 30-40 year investment horizon--a 6% back end sales load would cost you $60,000 if you took out all of the money upon retirement.

Why choosing actively managed mutual funds is a mistake

There are professional money managers who spend their whole entire life's work trying to time the market and, guess what... 92% of actively managed funds fail to match the returns of the market (i.e. S&P 500 index) over a 15 year period.

If your investment horizon is 15 years or greater- which includes you unless you plan on dying in the next 15 years- you stand practically no chance of picking the 8% of actively managed funds that will outperform the market. What's worse is that not only would the actively managed fund you chose have to beat the market, but it would need to beat it by at least 1.5 to 2.0%.

Why would it need to beat it by at least 1.5%? Fees and expenses. The average index fund has less than 0.1% in fees compared to the 2 plus percent fees of active funds.

​See why you are better off choosing index funds instead. 

I know many are thinking that 1 or 2% in fees doesn't sound like a lot, but trust me, it is. For example, saving even just 1% on fees could result in big differences compounded over time. Remember, the cost of a 1% fee could cost you $590,000 over 40 years, which is a very typical investment horizon.

WARNING: Your Financial Advisor Will Sound Very Convincing!

Remember, index funds- passively managed funds- do not generate revenue for your advisor's company. The index funds simply don't make money for your advisor because they do not have all of the above fees associated with them. Beware, your advisor might still charge an "advisor fee" or an "administration fee" which is why I am a firm believer in the DIY method of investing in index funds.

I promise that your current advisor will pitch you something like this:

Our advisement provides you expertly managed portfolios with industry leading research tools that often outperform index funds. We have an experienced staff dedicated to selecting blue chip funds that have demonstrated superior returns in recent market conditions.

This is literally what my advisor emailed me when I exited a high-cost fund through a previous employer's 401(k) program.

It's bullshit. Complete nonsense. Even if they do generate higher returns, it does not last. Never has. Likely never will. 

I am certain you will be able to find funds that outperform the market over 1-, 3-, or even 5-year periods. But outperforming index funds over your entire investment lifetime? Outperform for 30 or more years, in a row? They don't exist. Not one ever has. 

In Summary

Perhaps some of you are in a position to require a financial advisor. Some might need to receive tax advice. There are even some of you who are not willing to take just a few minutes to open your own account or call your advisor and inquire about fees and how to lower them by switching to passively managed index funds in your portfolio.

To those of you which this applies, I encourage you to seek the professional help that you require. Do not do so blindly however. Ask. Pick up the phone and have a few conversations with money managers and financial advisors. Be up front with them and ask immediately if this conversation will cost anything. Ask for free consultations as most money managers will be happy to provide a free initial chat.

Ask about fees. Ask about expenses. Ask about commissions. Be inquisitive and remember it is their job to answer all of your questions, even if most of them are about how the advisor gets paid. It's your money and to them, it's a job, so ask them about the costs associated with their account.

Your failure to ask could result in hundreds of thousands of dollars of expenses over a lifetime.

It's not unreasonable to think that if you start investing in your twenty's, and you live to be 90, you may be invested in the market for 70 years! Now imaging what those 2% fees will do to you compounded over 70 years. 

Be smart. Be curious. Don't be shy and don't be afraid to ask some questions. Even if you were able to save 1% in fees just by switching to passively managed funds, it could result in you retiring much earlier with a lot more money someday. It's worth it.

Until next time...

Comment below with your experiences with active vs. passive funds. Index funds vs. mutual funds. Run-ins with your advisors commissions. Please share with your community.