… but what exactly are they and how do they differ from what most investors are sold?
“The best way to own common stocks is through an index fund”
–Warren Buffett, Berkshire Hathaway shareholder letter, 1996
“The most efficient way to diversify a stock portfolio is with a low fee index fund”
–Paul Samuelson, the first American to win a Nobel Prize in Economics
Stock market index funds are similar to actively managed stock market mutual funds because they both hold baskets of stocks. But an index is different to an actively managed mutual fund because an index is meant to hold a group of (or nearly all) stocks in a given market, while an actively managed mutual fund is meant to trade a group of stocks. As such, there’s a cost difference that can’t often be overcome. The fees for the average U.S. mutual fund are 600% higher than the fees for a low cost index fund, when accounting for the expense ratio, 12B1 advertising fees, transaction costs, opportunity costs and sales costs. It’s a financial albatross that’s virtually impossible to overcome—no matter how great your advisor claims to be.
Here are the main differences between index funds and actively managed mutual funds. For simplicity, I’ll be using Vanguard’s total stock market index, which provides all the exposure to the U.S. market you’ll ever need. In essence, owning it is like owning slivers of shares in every public company in the U.S.
|Actively Managed Mutual Funds||Total Stock Market Index Fund|
|1. A fund manager buys and sells (trades) dozens or hundreds of stocks. The average fund has very few of the same stocks at the end of the year that it holds at the beginning of the year.||1. A fund manager buys a large group of stocks—more than a thousand. More than 96% of the stocks are the same from one year to the next. No “trading” occurs. A new business that enters the stock exchange will, however, be added to the index and any businesses that go bankrupt will no longer be part of the index.|
|2. The fund manager and his/her team do loads of research. Their high salaries compensate them for this, adding to the cost of the fund. This added cost is paid by investors.||2. No research is done on individual stocks. A total market index fund can literally be run by a computer. Its goal is to virtually own everything on the stock market so there are no “trading” decisions to make. This means that there are no research costs, and no high salaried fund managers to pay.|
|3. Stock trading (the buying and selling of stocks) within the fund generates commission expenses, which are taken out of the value of the mutual fund. The investors pay for these.||3. Because there’s no “trading” involved, commissions for buying and/or selling are extremely low. The savings are passed down to investors.|
|4. Trading triggers tax consequences that are passed down to the investor when the fund is held in a taxable account. The IRS sends you this bill.||4. The lack of trading means that, even in a taxable account, capital gains can grow with minimal annual taxation. You keep the IRS at bay.|
|5. They focus on certain stock sizes and sectors. For example, a small cap fund would own small companies only; a large cap fund would own large companies only; a value fund would own cheap companies only; a growth fund would own growth companies only; a medical sector fund would own medical companies only etc.||5. A total stock market index would own every category listed on the left—all wrapped up into one fund, because it owns “the entire stock market.”|
|6. Actively managed mutual funds (other than TIAA CREF) have owners who profit from the fund’s fees. The more fees that are raked from investors, the higher the profits for the fund company’s owners. You didn’t think banks and fund companies were charitable organizations did you?||6. A fund company like Vanguard is a “non profit” company. Nobody owns the company. Any “profits” made from the miniscule fee expenses go into operating the fund, and paying employee salaries. But there are no “owners”. If any “profits” are made by the fee costs exceeding salaries, the proceeds go towards lowering the fees.|
|7. Because mutual fund companies have “owners” who seek profits for their fund company, there are aggressive sales campaigns and incentives paid to salespeople (advisors) to recommend their funds for clients. The proceeds come from the fund’s assets, so investors pay for those.||7. A company like Vanguard doesn’t have owners seeking profits, so advertising is minimal.|
|8. Actively managed fund companies pay annual “trailer fees” to advisors, rewarding them for buying their funds. This money comes from the fund’s assets. In other words, investors pay for them.||8. A company like Vanguard doesn’t pay commissions or trailer fees to advisors.|
9. Most American fund companies charge sales or redemption fees—which go directly to the broker/advisor who sold you the fund. The investor pays for these.
9. Vanguard doesn’t charge sales fees or redemption fees.
10. Actively managed mutual fund companies are extremely well liked by advisors and brokers
|10. Vanguard puts money in your pockets—not in your advisor’s. And you still wonder why most investors don’t use index funds?|
If you owned a mutual fund company, and you realized that investors were catching on to the advantages of index funds, what would you do?
First, you’d train your sales staff to come up with the greatest stories they could to debunk what the greatest minds in finance have concluded about index funds. Your staff would have to come across as convincing—and come across as smarter than Economic Nobel Prize winners, and smarter than Warren Buffett, the world’s greatest investor.
But, as an owner of an actively managed mutual fund company, if your sales team fails you, you’ll need a back-up plan: you’ll need to offer your own “in house” index funds. But as an investor, you’ll want to be careful. Find out what the index funds cost, and don’t ever buy an index fund with a sales load. You should never pay an expense ratio of more than 0.3% for a U.S. stock index, or 0.4% for an International stock index either.
Vanguard’s total stock market index costs just 0.15% and their International stock index costs just 0.27%. Over time, they have been lowering their fees, while most fund companies have been raising theirs. Again, there is no fee to get in or out of either of these products—and your investment advisor isn’t likely to recommend them:
“When brokers realize that they won’t be compensated for putting our funds in a plan, they typically hang up on us.”
Vanguard, director of institutional sales.