Are Index Funds Better Than Mutual Funds for Young Investors?
As a financial advisor, one of the most common questions I get from young investors just starting to build their portfolios is whether they should invest in index funds or actively managed mutual funds. With a plethora of low-cost index funds now available that provide broad exposure to the market, many are wondering if the days of investing in traditional mutual funds are numbered.
While there are merits to both approaches, my view is that for most young investors, low-cost index funds are the better choice in today's environment. Here's why:
Lower Fees
One of the biggest advantages of index funds compared to actively managed mutual funds is their much lower expense ratios. Since index funds simply aim to track the performance of a benchmark index, there is no need to employ expensive fund managers to pick stocks. This passive approach translates to expense ratios that can be 1/10th or less the cost of the typical mutual fund1.
Over an investing lifetime, this difference in fees can really add up. Consider an investor who saves $10,000 per year for 40 years. Assuming an 8% annual return before fees, the investor would end up with nearly $280,000 more by investing in an index fund with a 0.05% expense ratio compared to a mutual fund charging 1%1. For a high net worth investor able to save even more each year, the difference could easily stretch into the millions of dollars. Keeping investment costs low is one of the most proven ways to increase your odds of long-term success.
Difficulty of Beating the Market
The primary pitch for investing in actively managed mutual funds is that skilled managers can outperform the market over time and earn you higher returns to justify their higher fees. Unfortunately, the data shows this is very difficult to do consistently. Over the 10-year period ending in 2021, only 26% of all active funds outperformed their passive benchmarks 2.
This inability for most mutual funds to beat the market is not a new phenomenon. In a seminal 1975 study titled "The Loser's Game", Charles Ellis argued that investors should adopt a passive, low-cost approach because "the investment management business (it is not a profession) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false." 3
Since Ellis wrote those words nearly 50 years ago, index funds have only proliferated and become easier than ever to access. Meanwhile, the hurdles for mutual fund managers to gain an edge continue to rise as markets get more efficient, making it harder than ever to outperform net of fees. For young investors with multi-decade horizons, the odds are not in your favor when trying to pick winning mutual funds that will beat the market.
Tax Efficiency
Another often overlooked advantage of index funds is that they tend to be more tax-efficient than actively managed mutual funds. Mutual funds that frequently buy and sell holdings usually generate more capital gains distributions that are taxable to the fund's investors each year. Index funds, on the other hand, typically have very low turnover and therefore generate much smaller taxable distributions 4.
This tax efficiency is especially beneficial for young investors who are likely investing in taxable brokerage accounts in addition to tax-advantaged retirement plans. By minimizing annual taxes on your investments, more money can stay invested and keep compounding over the long run.
Simplicity and Peace of Mind
Finally, index funds can provide young investors with simplicity and peace of mind. Building a diversified portfolio of index funds is relatively straightforward compared to the daunting task of researching and selecting actively managed funds. And once your portfolio is in place, index funds allow you to effectively put your investments on autopilot, freeing up time and mental energy to focus on your career and other financial priorities 5.
This is not to say that index investing is a panacea. Even a portfolio of index funds requires discipline to stay the course during inevitable market downturns. But by removing the temptation to chase the latest hot mutual fund or worry that you've picked the wrong manager, index funds can help young investors avoid common behavioral mistakes and maintain a long-term focus.
Risks and Limitations
Of course, no investment strategy is without risks. It's important for young investors to understand some of the potential limitations of an all index fund approach:
- Lack of Downside Protection - During sharp market selloffs, index funds will fall right along with the market, whereas some actively managed funds may be able to provide a degree of downside protection through defensive positioning 6.
- Giving Up Potential Outperformance - While the odds are stacked against mutual funds beating the market over the long run, talented managers can and do outperform at times. By solely investing in index funds, you are essentially giving up the possibility of earning above-market returns, even if the probability is low 7.
- Harder to Avoid Certain Risks - Index funds will give you exposure to the good and the bad of the market. If there are certain sectors, industries, or companies you want to avoid based on your values or concerns about their long-term viability, it can be harder to do with index funds compared to actively managed funds 8.
The Bottom Line
So where does this leave us? As with most investment decisions, there is no definitively right answer for all people. Investors must consider their unique goals, risk tolerance, and personal preferences.
However, I believe the evidence is clear that low-cost index funds should serve as the core of most investors' portfolios, especially young investors just starting to build long-term wealth. By keeping costs low, diversifying broadly, and avoiding the temptation to try to beat the market, index funds provide the best foundation for investment success.
This doesn't mean there is no role for active mutual funds. For investors with specific goals or values that cannot be easily met with index funds, carefully selected mutual funds can be a viable choice. The key is to keep them as a satellite holding in a core portfolio of index funds.
As a high net worth investor, you have likely accumulated significant assets through a combination of disciplined saving and smart investing. By allocating a large portion of your portfolio to index funds, you can preserve and grow that wealth in a proven, low-cost manner for generations to come. Don't let the siren song of beating the market distract you from the power of simplicity and discipline in achieving your family's long-term financial goals.
If you have additional questions about optimizing your investment strategy, I encourage you to reach out to a trusted financial advisor. With the right guidance and a steadfast focus on tried and true principles, you can achieve amazing results.
Meet
Dan Brady
Hi there 👋🏼 I'm Dan, an experienced professional with over 25 years in institutional trading and investing. My expertise lies in investment allocations, helping clients overcome financial challenges, and understanding their unique needs.
Reference:
[3] https://www.cfainstitute.org/en/research/financial-analysts-journal/2012/the-losers-game
[4] https://www.investopedia.com/articles/exchangetradedfunds/11/advantages-disadvantages-etfs.asp
[5] https://www.nerdwallet.com/article/investing/index-funds-vs-mutual-funds
[6] https://money.usnews.com/investing/articles/best-low-cost-index-funds
[7] https://www.investopedia.com/articles/exchangetradedfunds/08/etf-periodic-investment.asp
[8] https://www.nerdwallet.com/article/investing/how-to-invest-in-your-20s
Material prepared herein has been created for informational purposes only and should not be considered investment advice or a recommendation. Information was obtained from sources believed to be reliable but was not verified for accuracy. It is important to note that federal tax laws under the Internal Revenue Code (IRC) of the United States are subject to change, therefore it is the responsibility of taxpayers to verify their taxation obligations.
Savvy Wealth Inc. is a technology company. Savvy Advisors, Inc. is an SEC registered investment advisor. For purposes of this article, Savvy Wealth and Savvy Advisors together are referred to as “Savvy”. All advisory services are offered through Savvy Advisors, while technology is offered through Savvy Wealth. The views and opinions expressed herein are those of the speakers and authors and do not necessarily reflect the views or positions of Savvy Advisors.
