Choosing between Mutual Funds and Index Funds- Should We Have Both in our Portfolio?

Sun Sep 24, 2017 11:59:09AM | Categories: Financial Benefits

Charles Darwin in his theory of survival of the fittest has said that only, the one who adapts to the situation can survive and it has nothing to do with intelligence and strength. When, you apply this approach in financial investing it holds true their as well.

Everyday presents a new challenge. We have new debentures, corporate bonds, ETF's, stocks etc. that keep on coming up. Also, the returns on each of these asset classes keeps on varying. This means, that we need to do continuous portfolio evaluation and adapt accordingly, in order to generate better returns.

Break your portfolio down

Mutual funds are an effective method for investors to pool their money and buy more securities in the form of stocks, bonds or both than they can alone. The company would own the investments directly and investors hold portion of the fund in the form of units. Investment decisions are taken by analysts and domain experts who make investment decision. Though every mutual fund has its own structure, but this forms the basis of all of them.

ETF's also known as exchange traded funds are an investment vehicle which comprise of assets like stocks, bonds or commodities that are like mutual funds except they trade throughout the day similar to stocks.

Index funds are like mutual funds. They provide an investor access to a basket of securities with the exception that it doesn't engage in active buying and selling. They are un-managed. The objective of these funds is to copy an index. For example, S&P 500 index fund is a mutual fund that simply owns the same stocks that are there in S&P 500. As, there is no active management, analysts don't have to make estimations of stock movement. This is reflected in cost savings, as expense ratio of these funds is lower than that of Mutual Funds.

Truth Behind Performance

There was study in 2010 study called “The Equal Importance of Asset Allocation and Active Management” in which Roger Ibbotson studied 10 years of returns for more than 5,000 mutual funds available. He summed up his findings by saying that around 75% of fund’s variation comes from the general market movement trend. Rest 25%depends upon the asset allocation and active management. In other words, when a market rises it moves all the equity mutual funds higher.

Index funds make reasonable sense when investors think that markets are efficient. The idea behind this lies in "riding the tide". Is there going to be a difference in returns from index funds and mutual funds? Yes, there would be a difference. Will an active manager outperform? Maybe yes or no. But, according to the research and historical findings seventy five percent of return is dependent on market movement showing that index funds could be a good option.

Some investors opt to maintain a fixed strategy. Whereas, some are aligned to make decisions according to time and market movements. The advantage of using an index fund is that investors don't have to worry about day to day market movements. They only have to focus on asset allocation. They might make a percent less return, but since there overall portfolio remains balanced all the time, their risk also gets reduced.

Mutual funds have their own value and cost. Stocks tend to behave differently from one another and fund managers can potentially exploit that, especially in the later stages of market cycle. One of the shortcomings of an index fund is that regardless of a stock's price, it must own the stock and in proportion. For example, as of August 31, 2017 Microsoft represented about 3% of the S&P 500. Therefore, an S&P 500 index fund would have to hold Microsoft as 3% of its total holdings, and continue to buy at higher prices without considering it might have become expensive.

An active manager may look at Microsoft’s valuation and decide they do not want to own that much Microsoft and would rather invest elsewhere. Under such circumstances, stock selection can provide better returns. The same rationale is applicable for other assets. Is it worth paying an extra percent as expense ratio for this? When, it remains to be seen whether the stock will deliver or not.

The Gamble for generating extra return

If a manager fails to execute the strategy, that would lead to additional losses which will also include the extra expense ratio which you would be paying. Going back to the Ibbotson study again, it also said that active managers are trying to exploit that small inefficiency. There are many active managers who do not outperform the market in any given year, but they are able to outperform only in longer periods of time. This means, to get an advantage, investor would have to stick with same fund during the periods of underperformance. It would be like leaving a football game midway, only to realize that in second half the team made a comeback and won. There is no guarantee that fund will outperform. But, there is a good chance it will, according to the research done.

Which one to Choose Mutual Fund or Index Fund?

There is no right or wrong answer. It depends upon investor, his risk profile and time frame. Choosing the right portfolio manager can be the key while investing in Mutual Funds and requires extra due diligence.

But whatever, is your investing philosophy you would have to stick to it. Do you believe that markets are efficient or are you one of those who think it is inefficient and portfolio managers can generate better returns? Or maybe as some asset managers put it "markets are efficiently inefficient". If this is the case, perhaps a mix of both active and passive strategy can work best for investors.

About the Author

Harneet is an Engineer and MBA graduate from IMT Ghaziabad. He is the founder of The Buzz Stand, which is a digital marketing company in India and offers courses on basics of Finance as well. He is also a consultant with SAMT, which is an asset management company in Switzerland.

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