Do index funds outperform mutual funds?
Index funds offer lower fees and tax efficiency. Due to their passive nature, they often perform in line with market benchmarks, making them suitable for investors seeking broad market exposure at lower costs. On the other hand, active mutual funds aim to outperform the market by employing active management strategies.
Index funds offer lower fees and tax efficiency. Due to their passive nature, they often perform in line with market benchmarks, making them suitable for investors seeking broad market exposure at lower costs. On the other hand, active mutual funds aim to outperform the market by employing active management strategies.
Index funds tend to be low-cost, passive options that are well-suited for hands-off, long-term investors. Actively-managed mutual funds can be riskier and more expensive, but they have the potential for higher returns over time.
What Are the Results? Generally, when you look at mutual fund performance over the long run, you can see a trend of actively-managed funds underperforming the S&P 500 index. A common statistic is that the S&P 500 outperforms 80% of mutual funds. While this statistic is true in some years, it's not always the case.
| Focused funds | 5-year-return (%) | Benchmark index (%) |
|---|---|---|
| 360 ONE Focused Equity Fund | 22.21 | 17.61 |
| Franklin India Focused Equity Fund | 18.03 | 17.45 |
| HDFC Focused 30 Fund | 18.96 | 17.45 |
| ICICI Prudential Focused Equity Fund | 19.04 | 17.61 |
Index funds seek market-average returns, while active mutual funds try to outperform the market. Active mutual funds typically have higher fees than index funds. Index fund performance is relatively predictable; active mutual fund performance tends to be less so.
Over the full period, just 2% of actively managed Large-Cap Core funds beat the S&P 500. Even in categories such as small- and mid-sized stocks, and growth — which benefited from the tailwinds of an outperforming universe — a minimum of 81% of actively managed funds underperformed the benchmark.
Over the long term, index funds have generally outperformed other types of mutual funds. Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they're highly diversified).
Actively-managed mutual funds can be riskier investment options than index funds. With a portfolio manager trying to outperform the market, there's a chance they will make poor decisions that hurt the fund's performance.
Of course, you might also consider ETFs vs. mutual funds. Both are investment funds offering built-in diversification. However, unlike mutual funds, ETFs trade like stocks during regular market hours and may subject you to fewer taxes.
Why index funds don't work?
While indexes may be low cost and diversified, they prevent seizing opportunities elsewhere. Moreover, indexes do not provide protection from market corrections and crashes when an investor has a lot of exposure to stock index funds.
| Average Mutual Fund Returns | ||
|---|---|---|
| Category | 2021 Return | 10-Year |
| U.S. Mid-Cap Stock | 23.40% | 13.12% |
| U.S. Small-Cap Stock | 24.19% | 12.74% |
| International Large-Cap Stock | 9.72% | 7.85% |
I put my personal 401(k) and a lot of my mutual fund investing in four types of mutual funds: growth, growth and income, aggressive growth, and international. I personally spread mine in 25% of those four.
Warren Buffett has consistently recommended an S&P 500 index fund because it tracks a group of businesses that "are bound to do well" over time. The S&P 500 has been a profitable investment over every rolling 20-year period in history, and it returned 1,720% over the last 30 years.
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The average stock market return is about 10% per year, as measured by the S&P 500 index, but that 10% average rate is reduced by inflation. Investors can expect to lose purchasing power of 2% to 3% every year due to inflation.
Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition). To index invest, find an index, find a fund tracking that index, and then find a broker to buy shares in that fund.
Ideally, you should stay invested in equity index funds for the long run, i.e., at least 7 years. That is because investing in any equity instrument for the short-term is fraught with risks. And as we saw, the chances of getting positive returns improve when you give time to your investments.
Mutual funds come with many advantages, such as advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing. Disadvantages include high fees, tax inefficiency, poor trade execution, and the potential for management abuses.
If you were to stay invested for a shorter duration, say 20 years, you'd invest Rs 2,40,000, but your portfolio value would be Rs 9.89 lakh. A decade-long investment of Rs 1,000 per month would equal Rs. 2,30,038, as compared to Rs. 1,20,000 invested over the same period.
How much was $10,000 invested in the S&P 500 in 2000?
Think About This: $10,000 invested in the S&P 500 at the beginning of 2000 would have grown to $32,527 over 20 years — an average return of 6.07% per year.
| Fund Name | 5 Years Return | 10 Years Return |
|---|---|---|
| ICICI Prudential Value Discovery Fund (G) | 23.1% | 20.3% |
| Tata Infrastructure Fund (G) | 25.6% | 20.2% |
| Quant Small Cap Fund (G) | 36.8% | 20.1% |
| Bank of India Manufacturing & Infra fund (G) | 27.3% | 20.1% |
Even the top investors put their money in index funds.
In fact, a number of billionaire investors count S&P 500 index funds among their top holdings. Among those are Buffett's Berkshire Hathaway, Dalio's Bridgewater, and Griffin's Citadel.
And to go one step further, we recommend dividing your mutual fund investments equally between four types of funds: growth and income, growth, aggressive growth, and international.
Disadvantages of Index Funds
Index funds can dilute the possibility of big gains as they are driven by the combined results of a very large basket of assets. Little chance for big short-term gains. As passive investing vehicles, there's little scope for capturing big short-term gains with index funds.
