Deng Finance

Course: Mutual Funds Or Index Funds?

 At Deng finance, we heavily encourage the low-fee US index to get your fair share of the stock market with minimal to no risk. However, many individuals opt for actively managed mutual funds offered by top financial institutions in order “perform better than the index fund”. However, their high volatility, management fees, and tax inefficiencies is far from what investors believe.

 

Let’s say that we decide to invest $10,000  in the S&P 500 for 50 years at an annual return of around 10%. By the end of year 50, we are left with a whopping $1.2 million dollars! Now let’s assume that the average mutual fund operated at a cost of at least an assumed 2  percent fee per year. What’s the result? A net annual return of just 8 percent for the average fund. By the end of year 50, you’re left with only $469,000. That’s more than half the difference! The graphs shown here are powerfully illustrated to emphasize the impact management fees can have on your investments.

 

Another too often ignored cost that slashes further net return that investors receive are taxes. Oftentimes, the actively managed mutual fund is astonishingly tax-inefficient. Why? Because fund managers focus on the short-term, who too often are frenetic traders of stocks in the portfolios they manage. The average portfolio turnover (how quickly securities of a fund are bought/sold) of an actively managed mutual fund comes down to 78% a year. Due to this short-term focus, actively managed funds often distribute substantial short-term capital gains to their shareholders, which are heavily taxed compared to long-term capital gains like a index fund. The result? The average actively managed fund earns an annual after-tax of 8% per year, compared to the index fund at 10%. That’s 2 percentage points, as discussed in the previous paragraph, can slash your returns by more than half!

 

Many investors look at past performance and pick only the “good performers”. However, past returns are almost never an indication of further ones. Many mutual funds never even make it past the quarter-century. Out of 355 funds dating back to 1970, over 281 funds have gone out of business since 2016! How can you invest in the long term if your fund cannot even endure for so long? The odds of picking a successful fund are terrible, only two out of the 355 funds have delivered truly superior performance over the index fund. So, why not just buy the index fund instead of gambling with those odds?

 

We’ve laid out the facts, and the choice is yours. A high fee, tax inefficient mutual fund or a passive low fee index fund? 

 

 

 

Test Your Knowledge:
What makes mutual funds a bad investment?
Why are mutual funds tax inefficient?
Is past performance a good indicator of future performance?
Out of the 355 funds introduced in 1970, how many have gone out of business?

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