If there is a master list of life skills everyone needs, how to invest earns a spot near the top. Investing is a critical aspect of building wealth, and nearly everyone does it without the help of a trained expert.
Instead, these independent investors are leaning on websites, blogs, magazines, and newspapers to inform their investment choices. And not surprisingly, this isn't a fail-safe system. A FINRA Foundation investing quiz revealed some critical knowledge gaps among American investors. Among those gaps was this: Less than one-third of respondents could identify the main advantage of an index fund over an actively managed fund.
The answer is simpler than you might think. Index funds have lower fees than actively managed funds. That's an important factoid to know, because a fund's operating fees directly impact its performance.
Index funds: Market-level performance and low fees
An index fund is a mutual fund that's built to mirror the performance of a particular financial index, such as the S&P 500 or the Dow Jones Industrial Average. The index fund basically builds a portfolio with most or all of the assets that comprise the underlying index. Take the Vanguard 500 Index Fund (VFINX), for example. This fund invests in the S&P 500 companies so investors can expect it to grow in step with that index.
Because an index fund's portfolio doesn't change that much over time, it's a lot easier for a fund manager to take care of handling the fund without having to do analysis of stock picks on its own. This is called passive management, and this structure keeps the fund fees low.
Actively managed funds: strive to outperform, with higher fees
While an index fund strives for market-level performance, an actively managed fund strives to beat the market under the guidance of a fund manager. The fund manager actively trades assets in the portfolio to create returns for shareholders.
The presence of an active fund manager increases the fund's operating fees substantially. In theory, fund managers who do outperform the market essentially pay for themselves -- by delivering higher returns to offset those higher operating fees.
But sadly, this doesn't happen regularly. According to the SPIVA Scorecard, which tracks the performance of actively managed funds against their benchmarks, 71% of domestic equity funds underperformed the S&P Composite 1500 index in the 12 months ending in June 2019. Discrepancies were seen mostly in the large-cap funds, while small- and mid-cap fund managers had somewhat better performance.
The expense ratio: A key comparison point
All mutual funds, whether passively or actively managed, incur administration, marketing, and distribution fees. As noted, an actively managed fund has the additional expense of the fund manager. These fees are paid out of the fund's assets, which lowers the fund's total asset value and offsets a portion of returns.
As a mutual fund shareholder, you won't see these fees anywhere in your account. And if your shares show 8% growth, that's 8% after the expenses have been paid. What you should look for, though, is the fund's expense ratio. You can find it in the prospectus, and it represents fund fees as a percentage of fund assets.
The expense ratio is a key comparison point and success indicator for mutual funds. Consider two made-up funds, A and B. Fund A has an expense ratio of 1% and Fund B, an index fund, has an expense ratio of 0.15%. For both to produce a net return of 7% to shareholders, Fund A would have to grow 8% before fees. And Fund B? Its hurdle is only 7.15% before fees.
These made-up expense ratios aren't unrealistic. Expense ratios for actively managed funds typically range from 0.5% to 1.5%. Savvy investors target the bottom half of that range. A normal expense ratio on an index fund is much lower at 0.1% to 0.2%.
Low-cost index funds for your retirement portfolio
Here's your takeaway. Index funds are the building blocks of a solid retirement portfolio, thanks to their low-fee, passive structure. And now that you're armed with that bit of investing know-how, go out there and build some wealth.