Two important developments in the mutual fund’s industry have turned the tables in favor of the index mutual funds. These developments will be discussed in this article.

Mutual funds pool money together from a group of investors and invest that capital into different securities such as stocks, bonds, money market accounts, and others. Funds have different investment objectives, to which their portfolios are tailored.

Money managers are responsible for each fund. They generate income for investors by allocating assets within the fund. The reason why investors choose these mutual funds will be discussed further.

What Is a Mutual Fund?
5 Things You Should Know About Mutual Funds
Why do Some Investors Choose Mutual Funds?
What Is an Index Fund?
Why are Index Funds Growing in Popularity?
Why Would Someone use an Index Fund Instead of a Mutual Fund?
What Are the Reasons for the Growing Popularity of Index Funds?

What Is a Mutual Fund?

A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets.

Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.

Read Also: The 45 Cheapest Index Funds in The ETF Universe

Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund.

Mutual funds invest in a vast number of securities, and performance is usually tracked as the change in the total market cap of the fund—derived by the aggregating performance of the underlying investments.

5 Things You Should Know About Mutual Funds

Investing in index mutual funds and ETFs gets a lot of positive press, and rightly so. Index funds, at their best, offer a low-cost way for investors to track popular stock and bond market indexes. In many cases index funds outperform the majority of actively managed mutual funds.

One might think investing in index products is a no-brainer, a slam-dunk. However, to nobody’s surprise, the providers of mutual funds and exchange-traded funds (ETFs) have created a slew of new index products in response to the popularity of index investing.

Here are five things to know about index funds as you plan your investment strategy.

Not All Index Funds Are Cheap

People that work for large multi-national corporations often have the opportunity to invest in index funds offered in 401(k) plan that are dirt cheap institutional funds. If your 401(k) plan contains index funds from providers such as Vanguard Group or Fidelity Investments, you can be pretty certain these are low cost.

Both fund families offer share classes with even lower expense ratios and also offer a full range of index funds across various stock and bond asset classes.

Many 401(k) plans, unfortunately, do not offer index funds that are not this cheap. This may be true if your plan provider is an insurance company or brokerage firm offering their own proprietary funds.

While the advice to focus on index funds in your 401(k) plan is often sound, make sure that you look at the index funds offered in your plan to ensure that you are making the best choices. For 401(k) participants fortunate enough to have a selection of several low-cost index funds, the advantage over higher-cost active funds can be significant.

All Indexes Are Not Created Equal

There are a wide range of low-cost index mutual funds and ETFs covering widely used indexes across the nine domestic Morningstar style boxes, as well as widely used foreign stock indexes. The same holds true on the fixed income side of things.

The proliferation of ETF index products in recent years has led to a whole slew of index funds with underlying indexes that were essentially created in the “lab” with results that are largely back-tested as opposed to having real market results.

While back-testing is a valid analytical tool, investors need to be careful about ETFs using indexes that consist of a large amount of back-tested historical results. To my knowledge there are no rules governing the underlying assumptions used in applying this data and the simulated results may not be an accurate portrayal of the risks of ETF.

Index Funds Don’t Necessarily Reduce the Risk of Loss

Investors in an index fund or ETF tracking the S&P 500 during 2008 lost roughly 37% plus the fund’s expenses reflecting the decline in the underlying index. Investors in index products tracking real estate in the form of a real estate investment trust (REIT) or emerging market stocks suffered large losses as well.

Index fund investors do, however, eliminate manager risk. This is the risk of an active manager underperforming the benchmark associated with their investment style due to the investment choices they make in managing the fund.

Underlying Indexes May Change

Vanguard, who is a large player in both index mutual funds and ETFs, recently changed the underlying indexes for a number of their core index mutual funds such as Vanguard Mid Cap Index (VIMSX), Vanguard Small Cap Index (NAESX), and several others.

This was done in large part due to the fees Vanguard had to pay the previous index provider in an effort to maintain their status as one of the lowest-cost index fund shops. There doesn’t appear to have been an adverse impact here, but again, index fund investors need to stay on top of their holdings for changes like this, which we suspect will be more common as ETF and mutual fund providers continue to compete on price. 

Index Funds Don’t Ensure Investment Success

Just investing in an index fund or two doesn’t mean that you’re on your way towards achieving your investment or financial planning goals. Index funds are tools just like any other investment product. In order to gain the most benefit from using index funds either exclusively or in combination with active funds you need to have a strategy.

Index funds work quite well as part of an asset allocation plan. Index funds (at least the ones tracking basic core benchmarks) offer purity within their investment styles. Many financial advisers put together portfolios of index funds that are allocated in line with their client’s risk tolerance and their financial plan. 

Others may use a “core and explore” approach where index funds make up much of the portfolio (the core) with selected active funds to hopefully enhance returns (the explore portion).

Why do Some Investors Choose Mutual Funds?

Mutual funds can hold many different securities, which makes them very attractive investment options. Among the reasons why an individual may choose to buy mutual funds instead of individual stocks are diversification, convenience, and lower costs.

Diversification

Ask any investment professional, and they’ll likely tell you that one of the most important ways to reduce your risk is through diversification. It’s a lesson most people learned after the financial crisis. The underlying theme here is that you shouldn’t put all your eggs in one basket. So don’t just invest in one industry or one type of investment vehicle.

Many experts agree that almost all of the advantages of stock diversification (the benefits derived from buying a number of different stocks of companies operating in dissimilar sectors) are fully realized when a portfolio holds around holds 20 stocks from companies operating in different industries.

At that point, a large portion of the risk associated with investing has been diversified away. The remaining risk is deemed to be systematic risk or market-wide risk. Since most brokerage firms charge the same commission for one share or 5,000 shares, it can be difficult for an investor just starting out to buy into 20 different stocks.

That’s where mutual funds come into play. Mutual funds offer investors a great way to diversify their holdings instantly. Unlike stocks, investors can put a small amount of money into one or more funds and access a diverse pool of investment options.

So you can buy units in a mutual fund that invests in as many as 20 to 30 different securities. If you were looking for the same thing in the stock market, you’d have to invest much more capital to get the same results.

Mutual funds also invest in a variety of different sectors. So a large cap fund may invest across different industries like financials, technology, health care, and materials. Again, if you were to try to match this through individual stocks, you’d have to spend a lot of money to get the same returns.

Convenience

The convenience of mutual funds is surely one of the main reasons investors choose them to provide the equity portion of their portfolio, rather than buying individual shares themselves.

Some investors find that buying a few shares of a mutual fund that meets their basic investment criteria easier than finding out what the companies the fund invests in actually do, and if they are good quality investments. They’d prefer to leave the research and decision-making up to someone else.

Determining a portfolio’s asset allocation, researching individual stocks to find companies well-positioned for growth as well as keeping an eye on the markets is all very time-consuming. People devote entire careers to the stock market, and many still end up losing money on their investments.

Although investing in a mutual fund is certainly no guarantee that your investments will increase in value over time, it’s a good way to avoid some of the complicated decision-making involved in investing in stocks.

Many mutual funds offer investors a chance to buy into a specific industry or to buy stocks with a specific growth strategy. Here are a few options:

• Sector funds invest in companies within a specific industry or sector of the economy
• Growth funds focus on capital appreciation through a diversified portfolio of companies that have demonstrated above-average growth
• Value funds invest in companies that are undervalued and are normally held by long-term investors
• Index funds allow investors to track the overall market by constructing a portfolio that tries to match or track a market index
• Bond funds generate monthly income by investing in government and corporate bonds as well as other debt instruments

Costs

The costs of frequent stock trades can add up quickly for individual investors. Gains made from the stock’s price appreciation can be canceled out by the costs of completing a single sale of an investor’s shares of a given company. Investors who make a lot of trades should take a look at our list of brokers who charge lower-than-average fees.

With a mutual fund, however, the cost of trading is spread over all investors in the fund, thereby lowering the cost per individual. Many full-service brokerage firms make their money off of these trading costs, and the brokers working for them are encouraged to trade their clients’ shares on a regular basis.

Though the advice given by a broker may help clients make wise investment decisions, many investors find that the financial benefit of having a broker just doesn’t justify the costs.

It’s important to remember there are disadvantages of mutual fund investment as well, so as with any decision, educating yourself and learning about the bulk of available options is the best way to proceed.

Most online brokers have mutual fund screeners on their sites to help you find the mutual funds that fit your portfolio. You can also search out funds that can be purchased without generating a transaction fee or funds that charge low management fees. The search function can also let you locate funds that fit into a specific style of investing like socially responsible funds.

What Is an Index Fund?

An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor’s 500 Index (S&P 500).

An index mutual fund is said to provide broad market exposure, low operating expenses, and low portfolio turnover. These funds follow their benchmark index regardless of the state of the markets. 

Index funds are generally considered ideal core portfolio holdings for retirement accounts, such as individual retirement accounts (IRAs) and 401(k) accounts. Legendary investor Warren Buffett has recommended index funds as a haven for savings for the later years of life.

Rather than picking out individual stocks for investment, he has said, it makes more sense for the average investor to buy all of the S&P 500 companies at the low cost an index fund offers.

“Indexing” is a form of passive fund management. Instead of a fund portfolio manager actively stock picking and market timing—that is, choosing securities to invest in and strategizing when to buy and sell them—the fund manager builds a portfolio whose holdings mirror the securities of a particular index.

The idea is that by mimicking the profile of the index—the stock market as a whole, or a broad segment of it—the fund will match its performance as well.

There is an index, and an index fund, for nearly every financial market in existence. In the U.S, the most popular index funds track the S&P 500. But several other indexes are widely used as well, including:

• Russell 2000, made up of small-cap company stocks
• Wilshire 5000 Total Market Index, the largest U.S. equities index
• MSCI EAFE, consisting of foreign stocks from Europe, Australasia, and the Far East
• Barclays Capital U.S. Aggregate Bond Index, which follows the total bond market
• Nasdaq Composite, made up of 3,000 stocks listed on the Nasdaq exchange
• Dow Jones Industrial Average (DJIA), consisting of 30 large-cap companies

An index fund tracking the DJIA, for example, would invest in the same 30, large and publicly-owned companies that comprise that index.

Portfolios of index funds substantially only change when their benchmark indexes change. If the fund is following a weighted index, its managers may periodically re-balance the percentage of different securities to reflect the weight of their presence in the benchmark. Weighting is a method used to balance out the influence of any single holding in an index or a portfolio.

Why are Index Funds Growing in Popularity?

U.S. stock index funds are more popular than actively managed funds for the first time ever, according to investment research firm Morningstar. As of August 31, 2019, these index funds held $4.27 trillion in assets, compared to $4.25 trillion in active funds.

Index funds were created by Jack Bogle almost 45 years ago as a way for everyday investors to compete with the pros. They’re designed to be simple, all-in-one investments: Rather than picking stocks you or your fund manager thinks will out-perform the market, you own all of the stocks in a certain market index, like the S&P 500 or the Dow Jones Industrial Average.

Index funds have turned out to be a huge win for retirement savers and other non-finance professionals for many reasons.

First, because you’re not paying someone to pick stocks for you anymore, index funds tend to be less expensive for investors than actively managed funds: The average expense ratio of passive funds was 0.15% in 2018, compared to 0.67% for active funds, Morningstar reported. The original index fund, the Vanguard 500, has an expense ratio of just 0.04%.

Index funds also typically make trades less often than active funds, which leads to fewer fees and lower taxes.

“Costs really matter in investments,” investing icon Warren Buffett told CNBC in 2017. “If returns are going to be seven or 8% and you’re paying 1% for fees, that makes an enormous difference in how much money you’re going to have in retirement.”

Second, index funds tend to perform better over the long term than actively managed funds, making them ideal for people investing for retirement. It’s incredibly hard for a person to pick stocks that will beat the market and even harder to do so consistently over the decades.

In fact, the majority of large-cap funds have underperformed the S&P 500 for nine years running. “While a fund manager may outperform for a year or two, the outperformance does not persist,” CNBC reported. “After 10 years, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92% are trailing the index.” Large-cap funds are made up of publicly traded companies with the biggest market capitalizations.

Where active funds theoretically have a leg up is during periods of market volatility. The theory is that the managers will be able to shield their investors from some of the market’s deviations. But that wasn’t the case in 2018, for example, when managers still under-performed indexes, despite a rocky fourth quarter.

For the everyday investor looking to build wealth long term, that all adds up to make low-cost index funds a go-to investment.

“Consistently buy an S&P 500 low-cost index fund,” Buffett said. “I think it’s the thing that makes the most sense practically all of the time.”

Why Would Someone use an Index Fund Instead of a Mutual Fund?

When it comes to investing in index funds and mutual funds, investor have different preference. However, a lot of factors contributes to the reason why an investor will use an index fund instead of a mutual fund. We will discus that now.

So, what are the main differences between index funds and mutual funds? 

Investments

Both index funds and mutual funds are typically comprised of stocks, bonds and other securities. 

As is a given in the name, index funds focus on tracking the stocks that compose various indexes like the Nasdaq or S&P 500. 

Management Style

One of the major differences between an index fund and a mutual fund (especially an actively-managed one) is their management style – namely, whether they are active or passive.

Index funds are passive in management – meaning they are not actively trading or adding investments. Index funds are automated to track with a benchmark index like the S&P 500, so their investment mix is dependent on the underlying index. 

On the other hand, mutual funds are active in their management style – meaning that fund managers or analysts are actively picking fund holdings (like individual stocks, bonds or other securities). 

Objectives

Moreover, both mutual and index funds typically have different objectives or end goals.

For index funds, the general objective is to match the returns of the benchmark (or underlying) index before fees. So, essentially, the objective of the index fund is to generate the same amount of returns as the benchmark index minus the fees.

However, mutual funds generally aim to beat the returns of a comparable or related benchmark index after fees. Still, as a caveat, if the market is volatile (which is certainly the case currently), index funds may be harder to pull your funds out of on a moment’s notice given the “advance notice” requirement index funds have. 

Still, the objective of an index fund (to match returns) allows funds to keep fees and other costs low, leading to the next difference.  

Cost

What are index funds or mutual funds going to cost you? 

As mentioned earlier, mutual funds will tend to cost you more in fees (expense ratio), with fees ranging from around 1% to upward of 3%. On the other hand, index funds are generally lower cost, with annual fees ranging as low as 0.05% to 0.07% (although some may be slightly higher). 

For this reason, many investors cite the low fees as a major pull of index funds over mutual funds. 

Which Should You Choose? 

What’s best for your portfolio? 

This largely depends on your investment goals, attitude on a sector or index and funds available. 

Mutual fund 

• Better flexibility in moving assets around, given that index funds generally have low flexibility due to their passive nature. Choose a mutual fund if you want your fund manager to have the ability to hedge positions or move assets around with general ease. 
• Generally higher potential returns, given how mutual funds are more actively managed than index funds and are aiming to beat benchmark indexes. 
• Shorter-term trading due to how fund managers are able to trade more actively and capitalize on short-term gains than those tracking indexes. 

Index fund

• Lower fees and/or lower taxes on capital gains due to less turnover in stocks. 
• Access to big, global stocks without having to actively invest in individual companies. 
• A “set it and forget it” format – allowing you to invest in the fund and not have to track individual stocks or indexes every day.

Still, both mutual funds and index funds provide convenient and often high-revenue generating opportunities for investors, so be sure to do your homework and figure out what best fits your investment goals and experience. 

What Are the Reasons for the Growing Popularity of Index Funds?

Popular campaigns like Mutual Funds Sahi Hai and initiatives by many other mutual fund houses have helped attract more investors towards mutual funds in the last couple of years.

Historically, mutual fund investors have been more influenced by the market-beating returns generated by actively managed funds. But recently, there has been a paradigm shift in the way they perceive mutual funds.

Passively managed index funds and ETFs (that was kind of completely ignored category of funds by retail investors in India) have slowly started gaining momentum. Notably, the concept of index funds is quite popular in developed markets like the U.S.

Seeing the underperformance of the actively managed funds against the key benchmark indices like S&P BSE Sensex and Nifty 50 index in the last one year, many investors now want to get the taste of passively managed funds. It is noteworthy that passively managed funds tracking the popular index have managed to outperform their active peers by a noticeable margin.

All thanks to index heavyweights like Reliance Industries that have been driving the rally in larger indices.

Due to the increasing popularity in this space, mutual fund houses have launched index-based funds, vying for a piece of the pie.

• Mirae Asset Nifty 50 ETF
• Tata Nifty ETF
• Aditya Birla Sun Life Nifty Next 50 ETF
• ICICI Pru Nifty Next 50 ETF
• SBI-ETF Sensex Next 50
• ICICI Pru S&P BSE 500 ETF
• SBI Quality ETF

Currently, index funds are coming into the limelight for the following reasons.

1. Short-Term underperformance by Actively managed fundsIn February this year, the regulator mandated mutual fund houses to compare the returns of their scheme to Total Return Index (TRI) Benchmark. The shift from vanilla index returns to TRI gave a clear picture of the schemes’ performance versus its benchmark. This also enabled the investors to see that the alpha generated by the actively managed funds is disappointing. The number of actively managed funds outperforming the benchmark has come down and has even raised doubts in the minds of investors about the potential of actively managed funds.Followed by the short-term underperformance of actively managed funds, many investors doubt the human abilities to choose good companies on a consistent basis. In short, they are apprehensive about active portfolio management. Although they still recognise and acknowledge the importance of equity as an asset class and believe in the return potential of equity assets, there has been some shift in focus towards passively managed funds that mimic an index. It will be interesting to see how long this trend of underperformance by active fund managers will continue.
2. Lower expense ratioThe expenses charged by actively managed funds are much higher as compared to passively managed funds. While the expense ratio of actively managed funds varies within the range of 1.5%-2.5%, the passively managed index funds and ETFs typically have an expense ratio of about 0.25%-0.50%. Passively managed funds turn out to be more economical for investors and also boost the net returns the fund generates for its performance. Clearly, investors do not prefer paying someone a higher fee for poor performance.

Are investors right in switching to Index funds, now?

Index funds are popular in developed countries like the U.S. It is noteworthy that the U.S. is a saturated economy, where the active fund managers find it difficult to generate alpha over the benchmark. However, India is still a growing economy, which still offers lots of opportunity to active fund managers.

Read Also: The 7 Best Investment Banks of 2020

Notably, the size of the mutual fund industry in the U.S. is about 80% of its GDP, while the Indian mutual fund industry is just about 12% of the GDP. So, there is a long way to go before we get to a level where the active fund management becomes completely ineffective and redundant.

In our understanding, we are far away from having a complete passively managed fund industry. Do not forget, a large number of investors continue to prefer market-beating returns over market-linked returns.

If you wish to get the taste of passive investing, make sure you do not go overboard on index funds. Maintain a fair allocation between actively and passively managed funds. An allocation of 80:20 could be fair if you still aim to beat the markets.