If you asked me for advice to start investing, I’d first have to tell you that I legally cannot give specific investing and accounting advice. Then I’d tell you that both index funds and mutual funds are better ways to invest than single stocks. Then you might ask me which is better: mutual funds or index funds*? Here’s what I’d say …
*For clarification in this post, I’ll be discussing actively managed mutual funds and passive index funds.
What is an active mutual fund?
A mutual fund is a collection of funds from various individuals who have like-minded investing plans. Typically, a person will send her money to invest in a specific mutual fund. That mutual fund is overseen by a manager and a team of people who make the best decisions on how to use the money available to them. It’s just like you have a professional making all your decisions. They pick stocks and bonds that they think will beat the market average.
A mutual fund overseeing body will have a meeting where a bunch of geeks share reports and analysis. These experts will burn the midnight oil fighting about which are the best stocks to buy based on the likelihood that they will perform better than most other stocks.
Fund management is limited to the descriptions laid out in a document called a prospectus. Mutual fund #1 might focus on buying stocks from smaller companies. Mutual fund #2 might focus on buying stocks from big companies. You would purchase mutual funds from the company that had the best fees and management style according to your investing principles.
What is a passive index fund?
Similar to mutual funds, an index fund is a collection of funds from various individuals with like-minded investing plans. However, index funds don’t ever try and beat the market. Proponents of index funds believe that being average is better than taking a big swing and ending up behind average.
As an example, if you buy $100 of an S&P 500 index fund, what you are doing is buying a very small piece of stock from the 500 largest companies. If those stocks collectively go up, so does your index fund. If they collectively go down, so does your index fund. The simple reason is you own equal shares of all the stocks that are part of the index.
While there is a flurry of activity in the active mutual fund camp, in the index fund war room all you’ll hear is crickets. All the decisions have already been made.
Hey Hal, “did you use that $100,000 to buy $200 worth of stock at each the 500 companies that are part of the S&P 500?”
Alright then. Let’s call it a day.
Which is better? Index Funds or Passive Funds?
Reasons to Consider a Mutual Fund Investing Instead of an Index Fund
Have the Potential to Earn More Profit
The index fund industry will tell you flat out that their only goal is to stay even with the market.
However, there are some of us that tend to think average is not good enough. I was never satisfied finishing 20th place in a race of 40! I’m not sure the reality will turn out as planned, but mutual fund investors do undoubtedly have more potential to earn more profit. Ultimately, the question is: do they do it?
Reasons to Consider an Index Fund Investing Instead of a Mutual Fund
Less Operating Fees and Expenses
Remember that big team of smart people who is making decisions about your money. They don’t do it for free. You pay a part of every dollar you invest to support your team of experts.
With a mutual fund you can expect to pay an ongoing fee of anywhere between 1%-3% of the money you invest.
Index Funds, on the other hand, typically cost less than .10%. That’s because a computer automatically knows what to do, and there are no decisions to be made.
Fewer Investing Decisions
When I was investing in mutual funds through a financial advisor, at least once a year it would be time to add something to my portfolio for the sake of diversity. I’d get a hit list of 3-5 mutual funds to consider. Then I’d have to act like I had an idea how to choose which one is better, and then tell ‘my’ financial guy which mutual fund I wanted to buy.
With index fund investing, once you decide on your allocation (how much you want in each type of index fund), then you have fewer decisions along the way.
If taxes are a big consideration for you, an index fund might serve you better. With a mutual fund, stocks are always being bought and sold. For that reason, you can have capital gains even if you haven’t sold a mutual fund. However, with index funds, the investments stay invested so you don’t have capital gains until you sell. Here’s a primer on mutual fund tax implications.
More Diversification Options With Less Cash
If you have $1,000 to invest, you might be able to buy one mutual fund. However, if you by ETF index funds, you can own 4-10 different types of index funds.
So, I’m Obviously an Index Fund Guy, Right?
Well … Kind of. Sort of. If you asked me which I’d recommend to you, I’d probably say index funds. They offer a solid way to invest, and I think a person will likely do less damage with index fund investing than with mutual fund investing. If I say mutual funds and the thing blows up in your face, then I feel bad. At least with index funds I know you won’t do worse than the market.
When I first started investing, I was buying mutual funds with a 5% front end load. Without a doubt, I can say that was a dumb choice.
But, to be honest, the majority of my personal investments are in mutual funds. I follow the upgrading strategy and sector rotation through Sound Mind Investing. That’s because I’m young (tell that to my back), and feel like I’m willing to lag the market for a few years if the door is open for my investments to outperform the market.
That said, I do think it is time to start putting a portion of my retirement money in some index funds just as a way to diversity our holdings.
If index fund investing appeals to you because you are looking for a simple way to invest, you might consider Betterment.com. I was just introduced to these folks recently, and they help you set up an automatic withdrawal and then purchase a batch of index funds on your behalf. Yes, there are minimal fees involved with this (less than the mutual fund route), but if you want the easiest way to start investing in a healthy way, this could be a viable option for you.