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Financial Literacy

Financial Literacy

Home Financial Literacy Investing 101 Mutual Funds v. Index Funds

Mutual Funds v. Index Funds

The biggest issue facing mutual funds is not the competition of other mutual funds – it is index funds. Sadly, most mutual funds don’t hit even the bogey of the index fund return – AND they charge a lot more in fees/load – AND they buy and sell stocks a lot so they “realize gains” for tax purposes.

Do the math:

The S&P 500 Index is up 8% in an average year (average S&P index return for 100 years). Take Index or ETF is ticker: SPX. SPX charges 0.25% in fees with no loads. The ETF is super duper easy to buy and sell and there are no sales commissions (the brokerages who sell them get paid a tiny amount out of the monthly fees). So in an up 8% year, the investor shows a net gain after taxes of 8 – 0.25 or 7.75%. (There are almost none because the ETF doesn’t really trade much if any stocks or bonds in the index other than to rebalance.)

A median mutual fund investing in the same arena might return 6.5%. Let’s give hope the benefit of doubt and assume you were lucky enough to pick the top 20% of all mutual funds (think about that – it’s a huge benefit of the doubt) and that fund trades below the average “churn” of 50% . They “only” realize 30% of their net short term gains and 20% of their long term gains. In an up 8% year then, of the gain of 2.4% of short term gains, they cause you to pay about half of those gains back to the government (assuming you are in a Socialist state like California or New York) plus the Federal taxes plus other taxes and that you are in because of your reasonably high tax bracket.

Of the 2.4% you give back 1.2% to The Man. And that’s for the short term gains.
For the long term gains, you give back 25% in a normalish tax bracket situation. Of the 20% of 8% gains, that yields to you 1.6% and you give back 0.4%.

But wait! There’s more!

You have much higher fees in a mutual fund than an index fund so you pay that part first… let’s say you have a middlin’ load/no-load kind of fund and pay say, 1% a year, properly amortizing any load you might have.

Your return of 8% is 7% after fees. Then subtract the 1.2% of ordinary income gains and then another 0.4% of long term realized gains. Your nice 8% market return just became 5.4% versus the 7.75% return of the index fund.

It might not seem like much; however, the difference of that 2.35% per year over the course of a retirement lifetime leaves you with literally HALF of the money to retire on if you’ve been invested in this situation/scenario for 25 years.


If it sounds complicated, tough. You need to know this stuff. It’ll save you a fortune when you’re gray.

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