Ready to Invest? Index Funds vs. Managed Mutual Funds
The age-old argument in the investing world is about which type of mutual fund is a better investment: Are index funds, which are “passively managed” according to computer models better than all other mutual funds, which are “actively managed” by humans?
If you ask five experts, you may end up with six opinions. So, when the so-called experts can’t agree, where does that leave you?
If you want to start investing, it leaves you with having to choose one or the other anyway.
Here’s help: You can essentially separate your comparison into three main categories: philosophical, practical, and gut feeling. (Don’t expect to see this type of analysis anywhere else; but to me, there’s no better way to decide.)
The philosophical approach: Human vs. Machine
Where do you stand, philosophically, in the social discussion of a world in which computer-driven machines continue to replace the work of humans?
If you root for humans over machines, you should probably favor “actively managed” funds where real humans use their experience, smarts, and savvy to try making money.
Sometimes, these money managers will make brilliant decisions, and sometimes they’ll wish they could crawl into a hole and hide. But, hey, that’s being human.
If you’re psyched for a time when the world runs on techno, you’ll probably favor computer-driven index funds.
An index is a collection of specific stocks or bonds that the industry uses as a benchmark for investors (like mutual funds) to measure how their performance stacks up against the “overall market segment” performance.
Quick example: Managers of actively managed funds investing in international stocks will use the EAFE index as their measuring stick and try to beat it.
The people running an EAFE index fund, however, only want to mirror the performance of the EAFE index, not beat it. Their job is less labor intensive; they buy and sell every day based strictly on the results of their computer model.
Me? I’m a humanist who’d love to see people running our world instead of machines, most of the time. So at this point, I’m checking the “human” box on my ledger.
The practical approach: Cost vs. Benefit
First, let’s compare the costs of investing in one type of fund or the other, because there’s a clear winner.
Index funds cost less than actively managed funds, hands-down. Actively managed funds, run by one or more humans, charge, on average, 1.5 percent of the value of your money in the fund.
Index funds, relying on computer models (that don’t need salaries) charge, on average, about 0.2 percent of the value of your money in the fund.
In investing, cost plays a critical role in performance results (how much you make) that can’t be taken lightly.
Consider this:
Costs are like digging holes. Paying fees to a mutual fund to invest your money is like digging holes you need to fill before you can get back up to ground level and start growing your money.
Check out this comparative illustration of the impact fees have on how much you can earn over the course of 15 years.
If you invest for this every year for many years at this cost, at this annual return you’ll have this much:
Mutual Funds vs. Index Funds
| Amount invested each year | Number of years | Cost | Annual return | Total amount you will have |
|---|---|---|---|---|
| $1,000 - Actively managed fund | 15 | 1.5% per year | 7% per year | $32,991 |
| $1,000 - Index Funds | 15 | 0.2% per year | 7% per year | $40,161 |
| $1,000 - Index Funds | 15 | 0.2% per year | 6% per year | $34,885 |
As you can see, from a practical perspective, investing in an index fund (at an average fee of 0.2 percent) gives you a better chance of making more money than investing in an actively managed fund (at an average fee of 1.5 percent), simply by digging you into a shallower hole every year.
Do actively managed funds outperform index funds?
The short answer is no. The evidence is clear, despite what else you might hear.
Almost all fund managers can point to the years they outperformed index funds, but almost no manager can point to outperforming their comparable index fund every year, and few can point to outperforming that index fund over 10- and 20-year periods.
Humans sometimes do better than the market and sometimes do worse. Past performance doesn’t guarantee future success, and the past has validated this iconic statement.
Some critics of index funds argue that they “only let you do as well as the market average” but you’ll never experience the benefit of far outperforming the market. That’s an alluring argument, to be sure; but it’s superficial.
Index funds mirror “the market average” in a particular market segment. That’s very different than saying their performance is always “average.”
The market average, one year, can be a 23 percent return -- and many actively managed funds might only have a 10 or 15 percent return.
Even if an actively managed fund also achieves a 23 percent return, the index fund will still make you more money, because you’re paying less in fees.
The gut feeling approach
Here’s where I come down in my final analysis. You may, of course, feel differently. In my “human vs. machine” philosophy, I normally tilt toward “human” over “machine”—but not here.
The mutual fund culture is so married to the notion that most money managers deserve to earn multiple hundreds of thousands of dollars, plus bonuses.
As a result, actively managed fund are seven and a half times (on average) more costly than index funds. I like humans, but not enough to grossly overpay them at my own expense.
So, I suggest you seriously consider index funds. Many companies offer them.
Vanguard is generally considered the gold standard of index funds. Every extra penny you pay in fees means you need your mutual fund to earn an extra penny just to break even with the less expensive fund.
Maybe, someday, if money managers no longer are making salaries and bonuses I consider exorbitant, my predisposition toward humans will swing my choice the other way.
