ScaredyCatGuide to the 401(k) - Part 7: Mutual Funds vs. Index Funds

A war for your money has been raging for decades, with every piece of marketing material and mention of five-star ratings used to win you over.

Many fund fees are a percentage of assets. So the more assets the fund can pick up the more money they can generate for their firm.

Knowing this alone makes it hard enough to decide who to trust with your money. Having endless options does not make it any easier either.

As of April 2019 there were a total of 8,042 registered mutual funds (but only 4,397 individual stocks), all vying for a chance to help you beat the market.

Naturally most look for the top rated funds, that five-star rated market beating champion that will provide you outsized returns.

And here is the $17 trillion dollar secret (the total amount of money in mutual funds.

A mind blowing 90.46% of actively managed large cap funds have failed to beat the S&P 500 over the last 15 years, according to a SPIVA report.

The Standard & Poor’s 500 is widely regarded as the benchmark index for the U.S. stock market as it is made up of the 500 largest companies based on market capitalization. Names like Amazon, Apple, Google, AT&T and Bank of America make up the index.

When it comes to stocks it isn’t just large caps you can invest in though. There are mid-cap and small cap too. Maybe mutual funds perform better in that space?

Unfortunately, that is not the case. A total of 88.27% of mutual funds focused on mid-cap stocks and 89.08% focused on small cap stocks failed to outperform their respective benchmark indexes.

It is not just the stock funds either. As part of a retirement account you likely hold some bond funds and other fixed income type investments.

Bond fund managers did not fare any better than their stock managing constituents. According to the SPIVA report, 98.15% of long-term government bond fund managers failed to beat their respective Barclay’s index over the past 15 years.

It does not get much better when at corporate bond fund either. These are funds that invest in the bonds issued by companies such as Verizon and Caterpillar, they are considered “investment grade” meaning they have a high credit rating.

Investment grade long bond fund managers failed to outperform their respective index 96.77% of the time, only slightly better than the government bond fund managers.

Let these statistics sink in because when you look at the marketing material of the funds available in your 401(k) it will have a very different picture.

Some of those funds may have beaten the market the past year or two and look like sure things. The fund may beat the market in the current year as well, but we now know that over the long-haul it will likely underperform.

This viewpoint is worth keeping in mind because unless you are over the age of 50 than you have 15 or more years of investing until retirement.

Given these results what is a 401(k) investor to do? I mean, the whole point of paying for the active management of a mutual fund is to have the chance of receiving market beating returns.

This is where index funds come in handy. Remember, index funds have a lower cost structure because of their passive management. The main task for managers of these funds is to rebalance the fund portfolio as changes happen to the index it tracks.

For instance, if you invest in an index fund tracking the S&P 500 then the fund will mirror that index. It will add and subtract stocks as they are added and removed from the index itself.

The case for using index funds over mutual funds

From the earlier posts in this series we know that index funds are less expensive than mutual funds. We also know that every dollar we save on fees remains invested and earning even more due to the power of compounding.

Then we throw in the fact that the vast majority of mutual funds do not outperform the market over the long-term.

Combined, these items make a solid case on why you should consider switching to index funds in order to boost your 401(k) earning potential and to take back your retirement!

Posted Using LeoFinance