When it comes to investing their Roth IRAs, most individuals are best served by avoiding individual stocks and focusing on mutual funds. There’s a lot of talk in the investment world today about regular mutual funds vs. index funds. What’s the difference, and which is better for you—and your retirement account?
Know Your Fund’s Cost Structure
To answer the question, we first need to discuss costs. Mutual funds have varied cost structures, and these can greatly affect how large your nest egg grows. There are three ways mutual funds can structure their cost to you: expense ratios, front-end sales load and back-end sales load.
All mutual funds charge an investor a fee called an expense ratio. The fee is an ongoing percentage charge based on the amount the individual has invested. You’ll see mutual fund prospective reports that show something like “Expenses: 0.21%” or “Exp. Ratio: “0.75%.” This means that for every single dollar you invest into the fund, on an annual basis, the fund takes that percentage from your account. If you invested $10,000 in a fund with a expense ratio of 0.50% you would pay $50 per year in expense-ratio cost. If your balance the following year was $20,000 you would pay $100, and so on. Expense ratios range from as low as 0.15% to more than 1.5%.
Front-End Sales Load
This is a commission paid to the person selling you the investment (usually a broker or “financial advisor”). Sales loads can be quite costly. I’ve seen them as high as 5.75%. It’s called “front-end” because the fee is paid up front before your funds are invested. If you invested that same $10,000 from the example above you would automatically pay $575 in sales load fees! So your net investment would end up being $9,425. That’s less money to grow for your nest egg…and then you have to pay an expense ratio on top of that. Not all funds have a front-end sales load.
Back-End Sales Load
Likewise, not all funds have a back-end sales load. As you might figure, this is also a commission for your friendly financial salesperson…but it’s charged “on the back end,” when you sell your shares. The good news is, with back-end loads, 100% of your investment starts working for you right away (all $10,000 from the above example). The bad news is, if your fund shares’ worth grows to $1,000,000 over time, the commission percentage when you sell is based on that amount. In other words, you end up giving a huge chunk back to the investment firm.
As the name implies, these mutual funds charge no commission on either end, for buying or selling. All you pay is the expense ratio each year. Problem is, these can be pretty high as well, with the no-loads (you didn’t think you were getting off that easy, did you?), often north of the industry average around 1%.
Mutual Funds vs. Index Funds
Now let’s get into the difference between actively managed mutual funds and index funds, or mutual funds vs. index funds for short.
What Is an Actively Managed Mutual Fund?
An actively managed mutual fund is one that has a team of investment professionals running it behind the scenes. Living human beings with flaws, biases and unique perspectives on where the market (or more specifically the area of the market they focus on—“small cap growth stocks,” for example) is headed. This team works daily to make money for the fund. If the fund grows larger and does well for clients they stand to make more money based on the expense ratio the investors pay — and the likelihood that new investors will be drawn to a growing fund.
What Is an Index Mutual Fund?
An index mutual fund, also known as a passively managed fund, attempts to replicate the performance of a specific index. The investment team for an index mutual fund is usually smaller than that of an active fund, because less strategizing is required. Index fund managers don’t have to decide which is the next hot stock or growth opportunity. The index has a methodology for investing in an attempt to match the index it tracks. Any money invested in the fund is pushed through this methodology. An S&P 500 index fund, for example, might invest in every stock of the S&P 500 in an equal amount so that every dollar goes in 1/500th increments across all the stocks. When the fund receives new investments it just follows that methodology and pushes the money to the market in 1/500th increments.
Compare Active and Index Mutual Fund Costs
Which investment do you think is more expensive? The one with a team of human beings making unique decisions or the investment with a blanket strategy? You guessed it: Actively managed funds are more expensive than index funds. The average expense ratio for actively managed funds is 1.50% of assets. The same ratio hovers around 0.25% for index mutual funds.
If you invested in an actively managed fund at 1.5%, while a comparable index fund charged 0.25%, the fund managers would have to beat the market by at least 1.25% every single year. It’s plausible that an active fund can have an amazing run that beats an index over several years, but historically those funds have always come back down to earth. By investing in an actively managed mutual fund, you’re making an expensive bet that the fund team will continue to outperform the market.
Watch Out for Fund Marketing
The problem is, they often don’t. Sure, finance publications are full of advertisements from investment firms, touting how their funds have beaten every market index in the last one, three and five years. While that may be true, these funds are hiding a bit of information from you: Underperforming funds are swallowed up by funds that are performing well. This makes it relatively easy to make all of your mutual funds look like world-beaters. Fund A goes down dramatically, but Fund B performed really well last year. Give Fund A shareholders new shares of Fund B and close Fund A. Rinse and repeat; watch the profits rake in.
The ads for index funds, by contrast, focus on the only two things you can control: investment costs (expense ratios) and taxes.
If, in the mutual funds vs. index fund wars, we seem to lean towards the latter—you’re right. We do. By choosing an index investment you’re admitting that you can accept the average return of the index. No more, no less. It isn’t sexy, but by limiting your costs over the long term you can come out ahead.