Mutual Funds Vs. Index Funds: Why active management can kill your investments?

Did you know that you can lose 40% of the value of your investments over your lifetime due to high investment fees of actively managed mutual funds?

Imagine someone handing you a statement at the start of your working career and telling you that they’ll manage your investments for you. The catch: It could cost you hundreds of thousands of dollars in lost appreciation due to large investment commissions. Would you agree to that?

If you pay someone else to manage your money, you need to hear what I have to say.

If you have money invested in the stock market, you are probably invested in mutual funds. The mutual fund industry is a juggernaut in the financial world. In fact, the combined assets of Canada’s mutual fund industry totaled $1.51 trillion in June 2018.

But is investing in mutual funds right for you? While there is nothing wrong with having someone else manage your money, you must figure out if it’s really worth the cost.

Things like sales commissions, annual investment returns, and investment philosophy should be looked at with a fine-tooth comb. Rest assured, there is another way of investing!

In this article, I will talk about you about two popular ways of investing: Actively managed mutual funds and passive index funds. I will show you the pros and cons of each. Then I will close with why I recommend index investing as the right path to go.

What is a mutual fund?

A mutual fund is essentially a basket of stocks and bonds that may be invested in hundreds of different companies. You pool your money with others into a fund that will be invested into a portfolio of assets. The simplicity of a mutual fund allows you to invest into one fund that will diversify your money over a wide variety of areas.

A financial advisor will invest your money into a mutual fund based on a few factors. Lower risk investors will have a smaller percentage of money invested into stock and higher percentages into more fixed streams like bonds. The opposite is true for those with high risk portfolios.

From there, the fund manager from the mutual fund company will make the decisions on what stocks and bonds to purchase and when to buy and sell them.

You usually purchase mutual funds from a bank, a private investment company, or make regular contributions to your company pension plan that are invested into a group RRSP plan.

Companies like Vanguard, Blackrock, and State Street are some of the largest private investment firms that offer mutual funds. Average investors usually have their registered investments like an RRSP or TFSA invested into mutual funds to minimize tax implications.

Philosophy of a Mutual fund

Because Mutual Funds seek to beat the market returns, they may trade in and out of various securities to make that happen. Those decisions are made by a fund manager who decides how to best grow the fund. They are able to make quick decisions on which direction to go based on their own experience as well as current market data. As such, there are a some benefits to investing into a mutual fund

Pros of Mutual Funds

They are easy to purchase.

Mutual funds are easy to set up. After a meeting with your financial advisor to discuss your options, they will simply take the money that may already be in your bank account and invest it for you.

If you are invested in a group RRSP plan through your employer, they will have chosen a mutual fund provider to manage your money for you. If you set up regular automatic deductions, those funds will be directly diverted into your company’s mutual fund provider for investment on a regular basis.

Hands off management.

Rather than have the hassle of investing your own money, you can simply give it to someone else to handle for you. You will be sent regular statements to let you know how the fund is doing and a representative will usually meet with you once a year to make sure you are on track to meet your financial goals.

All of the day-to-day functions of your mutual fund operation are handled by someone else making it very easy for individual investors to participate.

Highly Diversified

Your investments in mutual funds are diversified across different asset classes like Canadian and American equities and foreign stocks and bonds. Your advisor will help you choose a risk level that is appropriate and set up a plan that works for you.

Having your money spread out among different industries and countries can help mitigate large losses when one sector suffers a downturn. When you don’t put all your eggs in basket, it helps during poor economic times such as we are seeing today with the COVID-19 pandemic.

Potential Higher Returns

Because a mutual fund seeks to beat the market returns, there may be the potential for more gains.  A fund manager has the ability to shift gears in a fairly short period of time if they see an opportunity that they believe will bring their fund higher returns.

Because a fund manager can incorporate both short term and long-term investment goals, their trading activity can be set up to maximize returns based on those market conditions. However, as you will see below, there are some very large downsides of investing into mutual funds that can reduce your overall gains.

Cons of Mutual Funds

They charge high fees

Mutual funds charge you an MER or management expense ratio that encompasses most of the fees associated with operating the mutual fund. This can include the day to day administration costs of running the fund, marketing, staff payroll, and the biggest cost is often paying the mutual fund manager themselves for making all the investment decisions.

Mutual funds charge high fees of anywhere from 1% to 3% of your entire investments to keep the operation running. In fact, Canada ranks third in countries with the highest investment fees losing out only to Taiwan and Italy.

For example, on a fund charging you 2% for investing in a mutual fund with a return of 6% in a given year, your returns will be diminished to 4% net of fees.

Due to the rather clandestine nature of mutual fund reporting, you won’t even see the dollars leaving your account. The fund will take their cut silently and only let you know what your take home returns are.

They charge extra fees

Front End Loading and Back End loading fees have been common practice for the mutual fund industry. Essentially both of these are charging a (%) fee at the front-end to get into the fund or charging you a fee to sell your investments if you leave the fund before a certain date. These two fees are not usually included in the MER.

They are not very transparent

This leads us to another large setback of mutual funds. In many cases, the actual total fees that a mutual fund will charge you will not be so clear. As mentioned above, you are charged an MER to invest your money into a mutual fund. The breakdown of those fees might not be readily available for you to see.

As well, many times the MER will not even be discussed unless an investor is asking the question directly. The fees charged might also encompass front-end or back end-loads or some other fee structure that might take some digging to uncover.

They keep some of your money in cash, un-invested

Since a mutual fund has many investors within it, there is always a need to keep cash on hand to pay those that might be leaving the fund and to make day to day purchasing deals. Having this ability to have a liquid supply of money on hand means that there will always be a portion of the fund that will be held in cash.

Many funds can have up to 5% of their funds in cash for these sorts of things. What that means for the investor is that a portion of their money might just be sitting there doing nothing and not appreciating at all.

Many mutual funds do not outperform the market over a consistent period of time

Many studies have shown that past performance is no indicator of future performance. Just because a mutual fund can show successes for a few years, does not mean that this translates into keeping those returns going on in the future.

It is important to look at how the fund has done over a long period of time to gauge its success. This can be difficult as mutual funds can be closed and opened at any time.

A study by S&P Global in 2017 found that only 34.11 % of large-cap mutual funds (funds that represent the biggest publicly traded companies) that existed in the prior 15 years were still around that year.

Under performing funds invariably close and the assets are then transferred to new funds. Since most funds do not outperform, this leads us to the conclusions that active fund managers do not have superior ability when it comes to investing in the markets. And those who do, are few and far between.

What is an index fund?

An index fund is part of the mutual fund family. In similar fashion, it may be comprised of hundreds of stocks and bonds representing many different companies. They have been created specifically to track a financial market index such as the Standard and Poor’s 500 (S&P 500) or Standard and Poor’s TSX 60 (S&P TSX 60).

“Owning the stock market over the long term is a winner’s game, but attempting to beat the market is a loser’s game.”

— John Bogle– Founder of Vanguard Group

Philosophy of an index fund

Because a passive investment strategy like indexing does not seek to beat the market like active mutual funds, there is no active trading. They only seek to match the returns of the broad-based index that it tracks. Index funds can represent a wide variety of the financial market from large cap stocks to small cap stock as well as bond index funds.

For example, you have probably heard of the S&P 500, S&P 60/ TSX. The S&P 500 tracks the largest 500 companies in the USA. Companies like Apple, Amazon, and Netflix are tracked in this index. The largest companies cover stocks that are listed on the NYE (New York stock exchange) and the tech heavy NASDAQ.

The S&P/ TSX 60 tracks the top 60 stocks in Canada on the Toronto Stock Exchange. Canada is heavy in natural resources and the financial sector, so you will see stocks like BMO, Scotiabank, and RBC exist here along with companies like SUNCOR, Enbridge, and Transcanada that round out the top spots on that list.

Today, the most popular way to gain exposure to these broad-based stock market indexes is to purchase them in Exchange Traded Funds (ETFs)

ETFs are a type of security that is comprised of a bunch of stocks and bonds, but can also include other types of investments that track an underlying index. They are found listed on stock market exchanges and they trade like an ordinary stock.

Pros of Index Funds

They charge low Fees

In an index fund, the investment securities are not selected by any fund manager, rather they are selected by simply matching the underlying exchange they are created to track. Since no one is trading investments in and out of the fund, they charge low investment fees.

Most mutual funds can charge you 2% of your investments or more to manage your accounts. In an index fund, you are charged a very small percentage of that. Many of the most popular broad-based index funds charge low fees of 0.02% to 0.07%. By investing a few diverse index fund ETF’s, your total portfolio costs could be less than 1% in total costs.

Remember how I told you that you could lose hundreds of thousands of dollars due to high investment fees? Here is an example of how that works assuming the following:

• $100,000 initial investment
• Annual returns of 7%
• compounded for 30 years

2% Investment Fee

1% Investment Fee

This possible index fund with a management fee of 1% increases your lifetime investment gains by $142,155!

You can find your own T-REX score (how much of your investment return you will actually get to keep) here courtesy of its creator Larry Bates.

Index funds are easy to understand.

When you purchase a mutual fund, the fund manager will invest your money in many different ways that might not be very clear to you even with an explanation. Since they believe they have the ability to beat the market, they can trade stocks and bonds as they see fit. You are not privy to what goes on in your fund.

In an index fund you know exactly what you are getting. There is no guessing. Each major company that you can purchase an index fund ETF from, will have the list of all the stocks in that ETF listed along with their associated expense ratio.

While Mutual funds will also give you that information, they are not as clear and can be very hard to decipher depending on who is providing it to you. Because holdings do change, those modifications are not always up to date.

Lower Risk and reliable growth

Research shows that for the average investor, index funds have reliable growth over the decades. The benchmark S&P 500 has been around since the 1920’s and is seen as a big indicator of stock market in the United States.

It has returned around 10% since its inception. It is also seen as a reliable indicator of the stock market. If investors put their money into this fund or broad based ones like it, their returns will be more or less predictable over a large period of time.

Because there is so much data available about index funds, we can be satisfied that it is a relatively lower risk investing option than having someone attempt to beat those gains through active trading on a regular basis.

You can buy them without a financial advisor

Low cost brokers like Wealthsimple and Questrade allow you to purchase index ETFs all by yourself. You don’t need an investment advisor and the process of opening up your own investment account is very simple.

You can manage your own registered accounts like the TFSA, RRSP, and RESP by yourself. By investing on your own, you lower the cost of your investment portfolio and it can be done by simply taking a few hours of your time to learn the basics of investing.

Cons of Index Funds

There is no flexibility in investments

Index funds do not have much room for being flexible. In any given index, the holdings rarely change. In times of volatility if the top holdings are doing poorly, they would bring the index down further thus reducing the share price of the ETF itself.

Potentially lower returns:

There is always the potential for outperforming the market if you employ an active investment philosophy like mutual funds. There are a small number of actively managed mutual funds that do outperform their base indexes. Even though those are few and far between, they do exist.

If you are one of the lucky ones to have your money invested with a fund that does outperform the market on a consistent basis, then you would lose out on this potential gain if you were invested only in index funds.

Conclusion

Mutual Funds and Index funds are the two most popular ways to invest your money. They have both pros and cons that make them attractive to investors.

Pros of Mutual Funds:

• Easy to purchase
• Hands off Management
• Highly Diversified
• Potential to beat the market

Cons of Mutual Funds

• They charge high Fees
• They charge extra fees
• They keep some of your money in cash and don’t invest it all
• They are not very transparent
• They do not outperform the market most of the time

Pros of Index Funds

• They charge lower fees
• They are easy to understand
• They have lower risk and reliable growth
• You can buy them without a financial advisor

Cons of Index Funds

• They have no flexibility of what you invest in
• They might have potential lower returns

In my opinion, if you are not part of the 1% of wealthiest investors, I would stick to investing in index funds.

The biggest reason is that index funds charge you lower fees than high price actively managed mutual funds. These low fees can save you hundreds of thousands of dollars over the course of your lifetime though simple investment strategies that work.

Since we aren’t all experts in the investing field, it is best to take the safe predictable road. It is not very sexy, but over the span of years and decades, your money will grow predictively in the market even when there are large market downturns like we have seen in 2020.

What is the easiest way to invest in index funds? By using a Robo-advisor, investors can get the benefit of low-cost money management created by the new financial technology sector.

Do you invest your money in passive index funds?