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Home Finance Investing Mutual Funds vs. Index Funds

Mutual Funds vs. Index Funds

You'd think that mutual funds get most of their competition from other mutual funds.

Not so.

For them, the Big Bad is the index fund. No matter how much mutual funds try to pretty up their image and slip into a little black dress, index funds outclass them. That's because index funds tend to outperform mutual fund—and they charge a lot less in commissions and fees.

The big difference? Mutual funds want to beat the market while index funds match the market. Imagine mutual funds as the guy in the funny sunglasses and the red sports car who wants to drag race, while index funds are the people who drive right beside you on the highway. The guy in the sports car might be flashier and look like he's going to go further, but because he's thinking about getting ahead of you, he might not notice that huge truck headed his way.

Oops.

Wanting to stay ahead of the market does have some big drawbacks.

Comparing Apples and Oranges?

To understand this story, you need to understand three key characters: 

1. Indexes are stock market indexes: numbers that refer to a bunch of stocks (examples: the Dow Jones Industrial Average and the S&P 500). When the stocks listed on these indexes go up, the indexes themselves go up. Simple.

2. Mutual funds are groups of investments (stocks and bonds) that are brought together and marketed by a stock fund manager. You can buy mutual funds and get some diversified stocks and bonds, but it costs a fee (and sometimes a commission known as a load).

3. Index funds are mutual funds that invest in the stocks of an index in the same ratio as the index itself. Let's say that there was a super-tiny index that just had three stocks, Stocks A, B, C (in addition to being small, this index had no imagination) and each of the stocks accounted for 33.3% of the index. If you put together an index fund based on this index, you'd buy 33.3% of each of stock A, B, and C. This means that if the index went up 3%, so would your index fund—they're pretty much the same thing in the same proportion.

So how does this work if you want to buy index funds or mutual funds?

Mutual fund managers want to beat the market. They want their mutual funds to trade higher than the index, so that they can brag about it, get that coffee mug with "#1 Investor" on it, and get even more people to buy their fund. The more people buy their fund, the more they make in commissions.

This means that managers need to beat the market now to show that they're choosing the "hot stuff." Unfortunately, that sometimes makes managers invest in "hot" stocks—rather than the ones that will do well in the long run—or buy and sell lots of stocks just to get their numbers up in the short term…even if it means losing money in the long run. Marketing is everything when you're trying to sell mutual funds.

It's like a celebrity throwing a public tantrum to get attention now; never mind that in the future, the Coen brothers won't be calling for an audition.

The Numbers

Let's take a closer look at the math.

The S&P 500 Index goes up 8% in a typical year (based on the average return for 100 years). An index fund based on this index might charge 0.25% with no loads or commissions. If your index fund goes up 8% in one year, you might have a net gain of 7.75% (just 0.25% gets taken off for taxes because index funds don't trade much stocks or bonds, which is where the big tax hit comes in with mutual funds and direct stock trading).

To compare, a typical mutual fund investing in some of the same stock might see returns of 4-6.5%. Why the difference? Well, most mutual funds underperform the market. But let's say you're super-smart (you didn't get into AP classes for nothing), and you happen to choose one of the just 20% of mutual funds in a given year to match or beat the market. Let's say your mutual fund gets you gains of 8%. You still only get about 5.4% net gain because you're going to have to pay taxes, loads, and fees.

And that's just one year.

If you invested for your retirement, that difference between net gains of 7.75% or 5.4% could mean your retirement budget is sliced in half because you've been seeing that smaller amount of investment over 25-30 years. Ouch. Now you can't afford the nice adult diapers and you get stuck with the ones that itch during your seniors' salsa classes.

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