What is a fund?
A fund is a pool of money collected from many investors to be invested in a portfolio of stocks. These funds are managed by professional money managers that invest the pool of money on the behalf of the investors. Funds are a hands off way for people to invest their money. Mutual funds are the most commonly held investment vehicle in people’s 401k accounts.
Index Fund
Index funds aren’t actively managed; they are the compilation of the stock market. Index funds don’t charge you very much in fees since they aren’t actively managed. The goal of the index fund is to replicate the performance of the market as a whole. There are different indexes representing performance of different segments of the market. There are S&P 500 index funds that track only the top 500 companies. There is the QQQ index fund that tracks the Nasdaq performance. There is the DIA that tracks the Dow Jones industrial average. These funds are a great way for investors to benefit from the growth of the economy while having a diverse portfolio that returns good returns year over year.
An example of index fund performance is this SPDR S&P 500 index fund. This fund tracks the performance of the top 500 companies. If you invested $5,000 in 1993 when the fund started today it would be worth $50,000.
Another example of an index fund is the QQQ index fund. This fund tracks the Nasdaq stock exchange. The Nasdaq stock exchange is composed of technology stocks. If you invested $5,000 when the fund started in 1999 you would have $31,600.
Mutual Funds
Mutual funds are still compilations of stocks. The difference is that compilation of them is actively managed by a fund manager. Mutual funds generally have the highest fees associated with them since they are actively managed. A very popular form of mutual funds is the target date funds available in 401Ks. These funds are actively managed to position its clients for retirement by the year of the target date fund. The mutual funds charge fees called expense ratios to actively manage the fund. Generally after the expense ratios mutual funds don’t give better returns than the market overall.
Lets cover an example of returns compared to investing in index funds.
The graph above shows the S&P 500 index compared to the returns of various Fidelity mutual funds over the course of 10 years. The blue line being the index and the other lines being the mutual funds. You can see from this example that investing in the index would have performed better over the course of those 10 years. Each of those mutual funds has a fee associated with it being actively managed. The expense ratio for the Fidelity funds is 0.75% where the expense ratio for the S&P 500 index fund is 0.25%.
Utilizing the fund calculator at NerdWallet we can see the fees associated with each of the funds.
The Fidelity fund above you would’ve returned 8.6% per year on average and then over those 10 years you would’ve paid $1,527.82 in fees to the fund. So at the end of 10 years your $10,000 would be valued at $21,291.27.
The S&P 500 index returned an average of 12.8% per year over those same 10 years and only had an expense ratio of 0.25%. You would’ve only paid $731.81 in fees and ended with $32,617.82.
The comparison demonstrates that using index funds you would’ve paid less than half in fees and gotten greater return to be invested in the low cost index fund than in the actively managed Fidelity mutual fund.
Exchange Traded Funds
Exchange traded funds(ETFs) can be traded like individual stocks on the market that’s where the name comes from. You can buy shares of these funds through your brokerage account just like stocks. The difference between this and mutual funds is that mutual funds are bought from the company operating the fund while ETFs are purchased from other investors participating in the stock market.
The managers of these ETFs try to compile stocks in ways that beat the market in the performance. Some ETFs specialize in dividend investing, others in advanced technology. In general most ETFs won’t outperform the stock market over a long time horizon. This would be a way to invest in a diverse array of stocks that could be different from the S&P 500.
One of the most famous examples of an ETF is ARK investing. This fund specializes in emerging technology stocks. During the covid era lockdowns their stocks skyrocketed and their performance was outpacing the market. As lockdowns ended and their technology stocks still failed to produce earnings to justify their valuation the ARK ETF started to come back to earth and its performance fell behind that of the S&P 500 over the existence of the ETF.
Conclusion
In conclusion it is difficult for funds to generate greater results than the market index over a long period of time. If you choose to invest in a mutual fund most of the time you will be paying large fees to perform worse than just investing in the broader market. Even if funds can perform greater than the market for a short time that often isn’t maintained over a larger time horizon. Investing in low cost index funds that track the S&P 500 will be the most profitable form of investing for people that want to invest in a hands off way.
Investors that want to pay attention to the market and want more than just a hands off way of investing they can pick their own stocks for their own custom portfolio. Retail investors have a better chance at beating the market themselves than these large funds and achieving a portfolio that beats the market over a long period of time. You can read more about that in this article about picking stocks.