Investing 101: Mutual funds and index funds.
This article is part 6 of the Investing 101 series. Remember that in the previous article, we looked at how difficult picking individual stocks can be. Therefore, many investors, especially long-term, passive investors, eschew picking stocks altogether and invest in funds instead. For this reason, mutual funds are the most popular investment products in the world.
Mutual funds are a “basket of stocks”
Some investors still want to pick stocks, but want to defer this to an expert instead of trying to pick stocks for their portfolio themselves. Other investors want to diversify by buying as many stocks as possible. Regardless of investing strategy, a mutual fund lets investors buy a single product which represents a “basket of stocks”, greatly simplifying the investment process. In my book, I discuss the history of mutual funds and index funds in some more detail. Today, there are two broad categories of mutual funds: actively-managed funds and passively-managed funds, also known as index funds.
Actively-managed funds are the oldest mutual funds in existence. They are run by one or more professional portfolio managers, who actively monitor market news and conditions and “cherry pick” the best stocks that go into their fund basket. The portfolio manager gets paid a percentage of the fund’s total assets under management as their fee, so naturally funds want to attract as many investors as possible. Funds competed with each other to get investor capital, and investors often flocked to famous fund managers and funds with a history of strong performance. The main benefit of an actively-managed fund is, of course, professional management. If a fund manager is skilled (or lucky), an actively managed fund can “cherry pick” a great basket and significantly outperform the market, or a different fund.
Passively-managed funds, also known as index funds, do not try to “cherry pick” the stocks that go into their basket. Instead, these funds simply track a market index, such as the S&P 500 that we discussed earlier, and buys all of the stocks included in the index in the same proportion as they are represented in the index itself. While the first index fund ever created was an S&P 500 index fund, there are now total market index funds which basically include almost all available stocks in proportion to their market capitalization. Index funds are largely automated and have no need to pay a professional portfolio manager for his or her stock-picking expertise. The main benefit of an index fund, then, is that the fees are lower than actively-managed funds.
In practice, the goal of an index fund is simply to replicate the returns of the market index itself. The goal of an actively managed fund is, obviously, to exceed the performance of a comparable market index, because otherwise, what’s the point of paying for professional stock picks?
Index funds were initially met with skepticism, because the idea of buying stocks indiscriminately ran contrary to the notion of evaluating companies to make good investment decisions. But over time, investors realized that most actively-managed mutual funds actually underperformed index funds! Every year, the S&P Index Versus Active (SPIVA) group releases reports on the performance of mutual funds compared to the S&P indices, and the results are never in favor of active management. How can robotically and indiscriminately investing in all companies outperform cherry picking from a professional cherry picker? The reasons are complex, but I’ll briefly discuss the two most likely:
Professional portfolio managers are just as bad at picking stocks as the average person. There is no consistent, systematic way to determine which stock is a good pick or bad pick for the future. In more general terms, this is an implication of something called the Efficient Market Hypothesis.
Active management incurs more fees. Since active trading is a zero-sum game, on average, active strategies will underperform the market average by an amount equal to the fees paid for active management.
For further discussion of this topic, I have an entire article on Active vs. Passive investing: which is better?
Regardless, over time, mutual funds and index funds have overwhelmingly become the most popular way to invest in the stock market.
Mutual fund characteristics and fees
All mutual funds share certain characteristics; index funds are just a subtype of mutual fund so these apply to index funds as well. By law, these characteristics are always publicly available in a document called the fund’s prospectus. Most of the important characteristics are also summarized online by the brokerage that offers the fund. For example, if you want to find out more about Fidelity’s S&P 500 index fund, Fidelity’s website for this fund has all the information you need, including links to the full prospectus. Most of this information is also available on third-party websites such as Morningstar or Yahoo Finance. For this section, I will use two funds, FXAIX and AGTHX, for illustrative purposes only. I do invest in FXAIX, but I am not making a recommendation for or against either of these funds. Always do your own research!
When you search for any fund, you’ll end up seeing a page something like this:
Fidelity’s landing page for FXAIX already shows almost everything you need to know. Screenshot taken from Fidelity.com on 04/15/2021.
Fund name. Every fund has a descriptive name which often reveals the contents or strategy of the fund. For this example, we will look at the Fidelity 500 Index Fund and the American Funds Growth Fund of America.
Fund ticker. Every fund has a unique ticker symbol, which is used to identify the fund on the market. For example, the Fidelity 500 Index Fund’s ticker is FXAIX and the American Funds Growth Fund of America’s ticker is AGTHX. If you want to buy a fund, you need to enter the ticker symbol in your brokerage account.
NAV. This stands for net asset value, which might also be shown as “price” by some services. This represents the price of one share of the fund, which changes based on the share price of the underlying stocks that the fund holds.
Performance/returns. Here, you can look at the fund’s historical performance. All funds will show their past performance, such as YTD, past 1 year, 3 year, 5 year, and 10 year annualized returns, as well as annualized returns since fund inception.
Fees. All funds do charge fees. This section is very important! There are several types of fees to watch out for.
Screenshot from Morningstar.com on 04/15/2021. Note the front load and expense ratio.
Load. This is a one-time transaction fee, or commission, in order to invest in the fund. This is expressed as a percentage of your purchase. There are two types of loads, front-load and back-load. The front-load is paid when you invest money into a fund, and the back-load is paid when you withdraw money from a fund. So called “loaded funds” are increasingly rare today, as investors have become more and more savvy about the impact of fees on their portfolio. In my opinion, funds with loads should be universally avoided. Many financial advisors will steer clients into loaded funds as this is how they earn their commission.
As an example, FXAIX has no load, so if you invest $10,000 into the fund, all $10,000 will go to buying fund shares. On the other hand, AGTHX is a loaded fund with a 5.75% front load (see screenshot above). This kind of fund is typically found in “managed” investment and retirement accounts. This means that if you invest $10,000 into AGTHX, $575 will go to your broker or financial advisor as commission, and only $9,425 will go to buying fund shares. You will lose 5.75% on your investment immediately!
Expense ratio. This is also visible in both screenshots above, under “net expense ratio”. This is a recurring, annual fee, which represents the ongoing cost to invest in the fund. Funds use this to pay for their operation expenses, including the salary of the portfolio management team for actively-managed funds. This is expressed as a percentage of your ongoing assets. This fee is unavoidable, as all funds incur operating expenses. For example, FXAIX has an expense ratio of 0.015%. This means that if you have $10,000 invested into FXAIX, you will pay $1.5 towards the fund’s operating expenses that year. Next year, if your investment grows to $20,000, you will pay $3, and so on. On the other hand, AGTHX has an expense ratio of 0.64%. This means that if you have $10,000 invested into AGTHX, you will pay $64 towards the fund’s operating expenses that year. In general, actively-managed funds have expense ratios which are orders of magnitude higher than that of index funds, because a professional portfolio management team isn’t cheap. Unfortunately, expense ratios directly take away from your returns, which is one of the reasons that actively-managed funds tend to underperform index funds over time.
AUM. This stands for assets under management, which is the total amount of money that is invested in the fund. AUM can be used as an indicator of a fund’s popularity and ability to attract investment capital. Sometimes also written as total assets, fund total assets, fund net assets, etc. In the screenshot above for FXAIX, Fidelity refers to it as “portfolio net assets”. You can see that FXAIX is managing over $308 billion dollars.
Holdings. This is a list of the top stocks held by the fund and the relative size of the holdings. Many funds will list their top 10 holdings on their website, but the fund’s full prospectus and summary will contain a comprehensive list of every holding. Unsurprisingly, FXAIX’s top holdings include Apple, Microsoft, Amazon, etc. This mirrors the companies in the S&P 500 index by market capitalization.
Turnover. This represents how much trading (buying and selling of holdings) occurs within the fund every year. Actively-managed funds tend to have much higher turnover than index funds, as the portfolio managers are constantly buying and selling stocks in their basket. But even index funds will have some turnover because it must buy and sell its holdings to match the index it tracks. For example, AGTHX had 28% turnover in 2020, and FXAIX had 7% turnover in 2020. All else being equal, turnover is generally undesirable because turnover creates capital gains (or losses) distributions which are taxable events.
Picking a fund
So how do you go about picking which mutual fund(s) to invest in? At first glance, this seems even harder than picking stocks! Although there are about 4,000 stocks in the U.S. stock market, there are about 8,000 different mutual funds! There are actually more mutual funds out there than there are stocks, because there’s an almost endless number of combinations and permutations of how to construct a fund from a choice of up to 4,000 stocks, and there’s also nothing preventing two different funds from having basically identical holdings, either by choice or coincidence.
There is no correct way to pick a fund. Some people pick funds based on their past performance, although this method can backfire. I recently wrote an article called Don’t Chase Past Performance, highlighting a famous historical example of this. Others pick funds based on their investment strategy, or the reputation of the fund manager. You will have to decide for yourself which funds you want to invest in.
In the past two decades, however, more and more people are investing in broad market index funds, such as S&P 500 index funds or total stock market index funds, to the point where index funds have surpassed actively-managed funds in total assets under management. Research has shown, time and time again, that actively-managed funds tend to underperform index funds due to fees. Many prominent investors, including John Bogle and Warren Buffet, have opined that index funds are the best way for most people to invest in the stock market, because they allow ordinary people to capture all of the returns of the overall stock market without paying exorbitant commissions to financial middlemen.
Finally, picking an index fund takes away much of the hand-wringing about which fund to pick. For example, once you’ve decided to go with an S&P 500 index fund, it’s as simple as picking a brokerage and investing. While there are dozens of S&P 500 index funds out there (each brokerage has its own version), they are, for all intents and purposes, functionally identical.
At the end of the day, I can’t tell you which funds to pick. But if you want to see the funds that A Frugal Doctor holds, my 2020 in review article has a complete list of my investments as of December 2020. Spoiler alert: it is almost entirely Vanguard and Fidelity index funds.
Summary
Let’s take a moment to recap the main points of this article:
Stocks can provide great returns to an investor, but picking stocks is hard.
A mutual fund makes this easier by being a “basket of stocks”, carefully cherry-picked by a professional portfolio manager.
An index fund is a type of mutual fund which follows a market index such as the S&P 500, and does not try to cherry-pick its basket.
You can find important information about any fund in the fund’s prospectus, on the fund’s website, or on any financial news website.
All funds have fees, but actively-managed funds have much higher fees than index funds due to professional management.
Despite this, actively-managed funds do not tend to outperform index funds over time, although there are some exceptions.
Avoid funds which have a load, or sales commission. These funds are usually pushed by financial advisors who profit from that commission.
Many investors believe that index funds are the best way for most people to invest in the stock market.
If you’ve made it this far, congratulations! Understanding mutual funds and index funds is the key to making sound long-term investments. These funds form the backbone (and in many cases, the entirety) of any investment portfolio. The next Investing 101 article covers bonds, an entirely different asset class. Happy investing!
