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Let’s cut to the chase – Mutual funds suck.
Did you know that in 2021, almost 80% of all actively managed mutual funds underperformed the stock market average? It is unbelievable that fund managers who dedicate their whole careers to studying the stock market could not outperform the S&P 500 in one of the most bullish years in history.
Beating the S&P 500 is a very challenging and time-consuming task. This is why at InvestaMind, we teach our readers to invest in index funds instead of mutual funds. Investing in index funds is the best investment strategy for anyone who wants to build wealth with a long enough time horizon.
In today’s post, I am going to provide you with concrete evidence as to why index funds are the best investment strategy for the stock market.
Why Is Investing In Index Funds The Best Investment Strategy?
Investing in index funds is the only way to guarantee long-term success in the stock market. Not only is it the most tax-efficient, but it also is the cheapest and easiest way to guarantee your share of profits.
1. Actively-managed mutual funds are incredibly expensive
Nobody works for free and neither do fund managers. Mutual funds rely on the expertise of their fund managers to pick the correct stocks that will outperform the market. These fund managers charge a hefty fee to invest your money into their fund which includes management fees and operating costs.
This fee is called an “expense ratio.” It is usually stated as a percentage and is deducted from your investments annually. For example, if you wanted to invest $10,000 in a mutual fund with an expense ratio of 2%, a total of $200 will be deducted from your investments every year.
Vanguard’s S&P 500 index fund has an expense ratio of 0.04%. Expense ratios of index funds are usually a fraction of mutual fund expense ratios. Let’s compare this with the 2% ratio mentioned above.
Take a look at the below data provided by begintoinvest.com.
The above visual compares two different funds as an example – one with a 0.04% expense ratio and another with a 2% expense ratio. If you were to stay invested for 30 years, the investment with the 2% would cost you a total of $259,269.87 more than the fund with 0.04%. That is more than a quarter million dollars!
As you can see, investment costs do matter.
Remember at the beginning of this article I mentioned that 80% of mutual funds underperformed the market? Imagine you invested in a fund that underperformed the market but also charged a hefty expense ratio. You wouldn’t be left with much of your hard-earned money.
Index funds have one of the lowest expense ratios because they are passively managed. All the fund manager does is make sure their fund is tracking the benchmark.
Index fund expense ratio can range anywhere from 0.09% down to 0.015%. Fidelity even offers 0% expense ratio index funds.
Keeping costs to a minimum is crucial to your success in investing, and index funds provide you with just that.
2. Past performance does not guarantee future performance
When looking for something new to invest in, nearly all investors take heavily into account its past performance. However, the past is what happened in the past. There is no guarantee of what will happen in the future.
Let’s take a look at a couple of concrete examples to illustrate my point.
Morningstar is a stock market research tool that many people use to evaluate investments. They have a star-rating system that rates funds from one to five stars, based on the fund’s returns in 3-, 5-, and 10-year periods.
In 2014, The Wall Street Journal did a study that tracked the Morningstar ratings on numerous five-star funds and found that after one decade, only 14% of the funds held their five-star rating. More than 36% lost a star and the remaining 50% lost two or more stars. The majority of the funds were not able to keep up with their performance.
Here’s another study.
Jack Bogle’s The Little Book of Common Sense Investing mentions a study that tracked the performance of 355 mutual funds over 46 years. Out of the 355 mutual funds, 281 went out of business. That’s almost 80%.
Many factors contribute to underperformance and failure. Fund managers change, and trends come and go. Investors flock to mutual funds with good track records and quickly sell out of underperforming funds, which heavily dictates the fund’s success. The more people that invest in a certain mutual fund, the less that fund can have an edge over the market.
A whopping 80% means the odds are certainly not in your favor. Not only did you have to be very lucky, but there is also no way to guarantee the fund you picked will continue performing well.
This is why the best investment strategy lies in index funds. Index funds buy the whole market without any need for stock-picking. This in turn eliminates the fear of underperforming.
3. Mutual funds are highly tax-inefficient
Mutual funds have a high turnover rate which results in more taxes you have to pay.
Turnover rate means the percentage of the mutual fund’s holdings that have changed throughout the past year.
The trend for speculative trading is increasing which increases the turnover rate in the fund. According to Investopedia, the average mutual fund turnover rate in 2019 was 63%. Compare that to mutual funds in the 1950s, the average turnover rate was only 16%!
High turnover rates are due to fund managers constantly buying and selling stocks throughout the year. They are constantly tweaking their strategies, trying to see which strategy works best. If you were to invest in a mutual fund with that high of a turnover rate, you would have to pay taxes on short-term gains which are taxed more heavily compared to long-term gains.
The average index fund turnover rate is only 3%, which is so much lower than the average mutual fund. Index funds can maintain a low turnover rate due to their passive nature of trading. All the fund manager has to do is make sure their fund is on track with the benchmark – no extra buying and selling, trying to outperform the market. The majority of tax triggers on index funds are from dividend distributions, which keeps taxation at a minimum.
Although a mutual fund may be able to temporarily outperform the market average, index fund investors are subject to lower taxes. You have no control over the fund manager’s strategy, and therefore, you don’t know how much taxes you are going to have to pay. Going back to the point I made earlier in this article, you want to make sure to keep your investment costs to a minimum.
Conclusion
Fund managers are not bad people. They are intelligent professionals that dedicate their whole careers to studying the stock market.
However, they don’t work for free. They charge hefty management fees for their services yet still manage to underperform. On top of that, their constant buying and selling of stocks trigger short-term tax gains that you will have to pay. Stop paying fund managers your hard-earned money and stick with index funds.
Not sure which index funds to invest in? We’ve got you covered. We wrote two other completely free articles – one covering domestic index funds and another covering international index funds. Make sure to check out both!
Remember, keep things simple with index funds.
Thank you so much for reading! Let me know your thoughts below in the comment section.