Why Indexing Is Replacing Mutual Funds

Posted on October 10, 2014 at 8:43 AM PDT by

In the early days of retail investing, buying stocks was hard. It took specialized knowledge. You had to know a licensed broker who worked at an exchange. Ordinary people just didn’t have access.

On balance that was a good thing, as the Great Crash of 1929 showed. Stock markets were volatile and an influx of inexperienced capital just added fuel the fire.

Fast forward a few decades. U.S. market matured, becoming much more liquid and far more stable. Big banks and insurance companies were the major players, and blue-chip stocks tended to grow more steadily, giving the markets much-needed financial ballast.


But ordinary people remained ill at ease with the mechanics of investing. Thus was born the mutual fund industry. Instead of picking stocks, you hired a manager to do the picking and the legwork of buying and selling.

It was a masterstroke of marketing and financial management, and for many years mutual funds earned their keep. As stocks went on bull tear after bull tear, the fees one paid to mutual fund managers seemed inconsequential in comparison.

Now the mutual fund business itself is being consumed, and mostly by its own success. With so many retail investors in the market and so much information being regulated and released to the markets, it’s increasingly difficult for any given fund to differentiate itself.

For a while, it might have seemed that small cap funds were the golden ticket. But even they are finding it difficult to outshine each other. Such is competition. Hedge funds were touted as the answer to providing value for the fees. Until the data failed to back up that promise.

So you have to ask yourself: What does my mutual fund really cost me, and is that price worth paying? Consider for a moment what you believe yourself to be buying in the first place:

1. Simplicity

Mutual funds are a single-ticker decision. Rather than own dozens of stocks you buy one fund. Perhaps you buy a small collection of them to create an asset allocation. And for that you probably pay about 1.5% in fees, extracted from your total portfolio every year.

2. Consistency

The idea of a stock mutual fund is that it owns just stocks. Of a bond fund, just bonds. Unless the manager strays, and that can happen, you are supposed to be holding a specific asset class for a specific reason.

3. Success

Defining success is a funny thing. Most people might say, “I want to beat the market,” even though they know in their hearts that’s unlikely and unsustainable. They might even say something more reasonable, such as “I want my money to grow at the minimum of necessary risk,” but do they know if that’s the goal of any given fund manager?

The time of mutual funds is quickly passing us by. They are being supplanted, largely, by index funds. Indexing offers simplicity (they own the entire index), consistency (they only own the index and nothing else) and success (an index funds always matches the market itself).

And they achieve that final goal, which is to grow money at a minimum of necessary risk, helping retirement investors achieve their own goals on time. All this in exchange for fees that add up to a tiny fraction compared to mutual funds.