Mutual funds are wonderful opportunities for investors to put their money in the hands of professional managers who have much more expertise and experience picking securities than most individuals do. But investors shouldn't take a hands-off approach when it comes to actively managed mutual funds. They need to keep a close eye on their investments and make sure managers are sticking to their strategies, keeping costs down, and making tax efficient decisions - not to mention generating consistent returns.
There is a way for individuals to invest in the markets at low costs and reap potentially good returns with little involvement on their part: index funds. Index funds, which invest in broad markets and sectors, exploded in popularity over the last several decades, with hundreds of index funds now available. These types of mutual funds are not actively managed. Rather, they are pegged to an index, such as the Standard & Poor's 500® Index. Index fund investors buy shares in an entire index instead of buying the individual stocks that comprise it. By simply investing in the same stocks that make up an index, index funds charge lower expenses, usually result in lower taxes, and have the potential to provide higher net returns than actively managed mutual funds on a long-term basis.
What is an index?
Indexes - or averages - represent and measure different segments of the market. They are used as benchmarks to compare the performance of other investments as well as act as investment vehicles themselves.
There are many other widely used indexes as well, including indexes of foreign markets, bonds, and various industry sectors.
Part of the reason index funds deliver excellent returns is because they don't require the resources of active management and are able to keep expense ratios very low as a result. The average expense ratio of an actively managed U.S. stock mutual fund is around 1.5%, while an index fund may have an expense ratio as low as 0.12%.
Actively managed funds generally buy and sell securities at a much greater rate than index funds. Trading may trigger capital gains that are passed on to fund investors every year. When the fund has net capital gains, its shareholders must pay taxes on the capital gain distributions even if they are reinvested. The average annual turnover rate for actively managed funds is more than 40%. This means that at the end of every year the average mutual fund only owns 60% of the same shares with which it started the year. Index funds typically turn over less than 5% of their portfolio per year. A stock is sold by the index fund only if a company is removed from an index or investors redeem shares. Because stock turnover in index funds is low, amounts that must be paid out and/or taxed in the form of capital gains is minimized. Therefore, amounts retained in the fund are typically larger than in other mutual funds, and these retained funds are available to produce additional investment returns.
But the biggest reason index funds have become so popular is because of their above-average past performance. Almost 75% of actively managed mutual funds underperform the market average, especially after fees are subtracted. Mutual fund managers are at a slight disadvantage here because the costs of trading and running the fund cut into their performance numbers. Index funds have also benefitted from the fact that, historically, markets have risen more than they have fallen. Over the past 50 years, the S&P 500 has gained an average of more than 12% annually (with dividends reinvested) - not a bad return over the long haul. Keep in mind, however, that some index funds don't track their indexes as closely as they should, especially if their expense ratios are relatively high.
With so many index funds to choose from, an investor could create a well-diversified portfolio with only index funds - and that may make sense for some investors. However, there are still great benefits to investing in actively managed mutual funds as well.
Index funds stay fully invested in their respective index, even if that index is tanking. Active managers, on the other hand, can protect portfolios when the market takes a turn for the worse and seek out buying opportunities when it bottoms.
Standard & Poor's 500 and S&P 500 are registered trademarks of Standard & Poor's Corporation, a division of The McGraw-Hill Companies, Inc.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.