The Death Of Mutual Funds

Many investors feel that mutual funds are the best thing since sliced bread and for good reasons. Mutual funds are easy to invest in, they have low expenses, they offer instant diversification, etc. But how good of investments are mutual funds…

Not very good ones when you compare them to index funds. An index fund is one whose goal is to match the target index as closely as possible. They may try to replicate the the S&P 500, Russell 2000, Wilshire 5000, etc.

So why are Index funds better than Mutual Funds?

Only about 30% of mutual funds beat the S&P 500 in any given single year.

And if you are lucky enough to pick one of the 30% that do beat the S&P, how likely is it that the fund will beat the S&P in 2 straight years, or 5 straight years or even 30 straight years?

Let’s take a look at some facts.

The largest and most well-known index fund is the Vanguard S&P 500 Index Fund. This index fund attempts to match the Standard & Poor’s 500 Index. How well has it done?

Over the last ten years it has beaten the performance of over 90% of all domestic equity mutual funds over the past three and five year periods! Are you a good enough investor (or lucky enough) to be able to pick the 10% of mutual funds that will beat the S&P Index? Probably not, sorry.

Here is another fact. During the 1990s, the S&P 500 provided an annualized return of 17.3%, compared with just 13.9% for the average diversified mutual fund. (Fool.com).

If you invested $100,000 at 17.3%, after 10 years your investment would have grown to $493,151.

If you invested $100,000 at 13.9%, after 10 years your investment would have only grown to $367,482. A difference of $125,669!

But the advantages of index funds doesn’t stop there. The expense ratio of the average mutual fund is about 1.5%. By comparison, the Vanguard S&P 500 expense ratio is 0.19%.. When you factor in the expense ratio differences the gap widens to $163,364!

Better yet, index funds can even outperform the index they are replicating because any dividends are also distributed to fund shareholders.

So why do mutual funds continue to be so popular? Well, there isn’t much money to be made by investment advisor’s who put their clients in index funds. They make a whole lot more money from mutual funds. But investment advisor’s wouldn’t put their clients in an investment that performs worst just to make more money would they? Hmmmm.

Another factor is that index funds are simple and there isn’t much to talk about with them. Investment magazines would have little to write about if they just told you to pick an index fund. Talking about mutual funds gives them much more to talk about.

So next time you are researching the latest and greatest mutual fund to invest in, give you self a break, save your time and just choose an index fund. Chances are you will come out better.