Why Mutual Funds are better than Index Funds
 

I have heard many people criticize Mutual Funds, especially in comparision to Index funds, citing two main reasons:

-80% are outperformed by the S&P 500
-managment fees are too high

Thus they put their money into index funds. But nobody seems to figure out that the reason most underperform the index is in order to create less fluctuation (variance) for those who want to generate income from their investments (generally older people close to or past their retirement). Most of these people would freak if they saw the swings the indexes take. So the Mutual fund industry is trying to appease the requirments of their clients.

Secondly, there are still the remaining 20% that outperform the market with proven track records and excellent managers at their helm. There are thousands of Mutual funds to choose from, and you should only place your money in a few of the best ones. There are all sorts of books generated on a yearly basis giving the top picks.

Therefore, when you select a mutual fund that has outperformed the index over ten years after management expenses, and with less fluctuation, you have a winner. It is worth the management expense.

If people are serious about making money on the markets, they should not buy index funds. A good value invested Mutual Fund is superior.

Re: Why Mutual Funds are better than Index Funds
 

You need to rethink you investment thesis and match the appropriate index to the mutual fund you are going to buy. If you own a mutual fund that is 100% large cap equity comp that against the S&P 500 index. Most older investors will start to move towards balanced funds that produce dividend income and slower growth (lower risk) which produces uncorrelated returns to the S&P 500.

Most mutual funds managers will try to closely emulate the index that they are comped against and rarely deviate from the underlying securities thus perpetuating the average performance of fund managers. In mutual fund world it's all about the management fees not stellar performance.

Re: Why Mutual Funds are better than Index Funds
 

Meh.
Prior performance is no indication of future performance. The reason actively managed funds underperform index funds is the MER difference, pure and simple.

In the last couple of decades, when the total market returned 10+%/a, a 2% MER was painful but bearable. With the market probably returning <7%/a over the next couple of decades....ugly.

Re: Why Mutual Funds are better than Index Funds
 

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Therefore, when you select a mutual fund that has outperformed the index over ten years after management expenses, and with less fluctuation, you have a winner. It is worth the management expense.

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Could you provide a few examples and the corresponding data?

Re: Why Mutual Funds are better than Index Funds
 

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With the market probably returning <7%/a over the next couple of decades....

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Interesting comment. What do you base this on and what is your best estimate of the ex ante return on the market?

Re: Why Mutual Funds are better than Index Funds
 

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Most mutual funds managers will try to closely emulate the index that they are comped against and rarely deviate from the underlying securities thus perpetuating the average performance of fund managers. In mutual fund world it's all about the management fees not stellar performance.

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Be careful. Yes, the mutual fund management company earns fees based on assets under management, but the level of assets under management does vary, to some degree, based on the fund's performance. Fund's with strong performance tend to grow faster than Fund's with weak performance, and larger funds generate increased management fees.

Also, the portfolio management personnel at mutual fund companies usually are compensated based on peer group comparisons, not index comparisons. So, a small cap growth fund manager is probably compensated based on his ability to outpeform other small cap growth fund managers. In a given year, all of the managers may outperform (or underperform) the index, but only the managers who perform best will be rewarded...and the managers at the bottom of the ranking will often lose their job (after two consecurive years of underperformance, a manager is usually fired or on probation).

So, mutual fund companies are incented to perform well. And managers have strong incentives to perform well. And 'well' is generally defined by comparing one fund manager to another manager, not by comparing managers to indices.

And, yes, another key reason that funds underperform indices is that the funds are incented to preserve capital in down markets (as the original poster suggested).

Re: Why Mutual Funds are better than Index Funds
 

Interesting, I thought investors evaluated managers on their ability to outperform the no-brainer-low cost alternatives (indexes)which is quite different that how you characterize the internal grading system for a fund family. I guess that's why Stansky at Fidelity Magellan still has his job after underperforming the S&P index for all these years!!!

Re: Why Mutual Funds are better than Index Funds
 

player24 - Good post

adios - Keep on asking the tough questions.

Re: Why Mutual Funds are better than Index Funds
 

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Secondly, there are still the remaining 20% that outperform the market with proven track records and excellent managers at their helm.

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I thought only 20% outperform the indexes in a given year. Only a couple have done it for over a decade or so. These also tend to be the funds with higher variance than the indexes, not steadier gains (generally because they have more concentrated portfolos). Bill Miller's teams in the 90's or Peter Lynch's in the 80's come to mind. But as their assets grow, their chances of beating the market are likely to diminish. Index Funds are and should remain the safest way to get the best return for the least work for any equity investor.

Re: Why Mutual Funds are better than Index Funds
 

Not to split hairs here, but an index fund is just a mutual fund based on an index. If someone is considering a fund, why wouldn't you want to look at the entire universe of funds? It doesn't seem to me than you gain anything by limiting your options. fwiw