A mutual fund is a type of investment vehicle that pools money from many investors. It then uses that money to buy a diversified portfolio of stocks, bonds, or other securities. Mutual funds are managed by professional investment managers. These managers use their expertise to select the individual assets that make up the fund’s portfolio.
Advantages And Downsides Of Mutual Funds
One of the main advantages of investing in mutual funds is that they provide investors with diversification. This means that by investing in a single mutual fund, an investor can gain exposure to a wide range of different assets, rather than having to buy each individual asset separately. This can help to reduce risk. It ensures that the investor’s money is spread out across many different investments, rather than being concentrated.
Another advantage of mutual funds is that they are relatively easy to invest in. Unlike some other types of investment vehicles, mutual funds are widely available and can be bought and sold through most brokerage firms. They also typically have low minimum investment requirements, which makes them accessible to investors with limited capital.
Despite these advantages, however, mutual funds have been criticized for producing lower-than-average financial results in recent years. This is because mutual funds typically have higher fees than other types of investment vehicles, such as index funds or exchange-traded funds (ETFs). These fees can eat into the returns earned by investors, reducing the overall performance of the fund.
This investment approach has not been shown to consistently produce better returns than simply investing in the market as a whole, and many mutual funds end up underperforming the market as a result. Mutual funds have been criticized for producing lower-than-average financial results due to their higher fees and active management approach.
Why Mutual Funds Are Worse Than ETFs – An Example
Let’s say that you have $10,000 to invest and you’re considering two different investment options: a mutual fund and an ETF. Both of these options invest in the same basket of stocks, which are expected to return an average of 10% per year. However, the mutual fund has an expense ratio of 1%, while the ETF has an expense ratio of 0.1%.
After one year, the basket of stocks returns 10% as expected. The mutual fund, with its 1% expense ratio, would have earned $900 in returns after fees ($10,000 x (10% – 1%). The ETF, on the other hand, would have earned $999 in returns after fees ($10,000 x 10% – $10,000 x 0.1%).
In this example, the ETF has outperformed the mutual fund because it has a lower expense ratio. The mutual fund’s higher fees have eaten into its returns, reducing the overall performance of the fund. This is just one example of how mutual funds can perform worse than ETFs, but it illustrates the impact that fees can have on the returns earned by investors.
Compounding Makes The Difference Grow Over Time
Compounding refers to the process by which an asset’s returns are reinvested to generate additional returns over time. This can amplify the impact of fees on an investment’s overall performance, as the fees are charged on both the original investment and on any returns that are generated through compounding.
To illustrate how this works, let’s continue with the example from earlier. In this example, we have a mutual fund and an ETF that both invest in the same basket of stocks and have the same expected return of 10% per year. However, the mutual fund has an expense ratio of 1%, while the ETF has an expense ratio of 0.1%.
We’ve reviewed the first year performance where the funds end up with $10,900 and $10,999, respectively. This is not a massive difference per se. Let’s look at what happens after that.
After the second year, the mutual fund has an ending balance of $11,881. The ETF has an ending balance of $12,078. The difference in ending balances may still seem small, but they’ve added up and over time can add up significantly. The higher fees charged by the mutual fund are compounding. They are reducing the returns earned by the fund and leading to lower overall performance compared to the ETF.
Compounding can make the impact of fees on an investment’s performance worse. This is because it amplifies the effect of the fees over time. This can lead to mutual funds underperforming compared to other types of investment vehicles with lower fees, such as ETFs.
After 10 Years, The Compounding Makes It Get Even Worse
To determine the result after 25 years, we would need to continue compounding the returns. Based on the example from earlier, where both the mutual fund and the ETF have an expected return of 10% per year and the mutual fund has an expense ratio of 1%, while the ETF has an expense ratio of 0.1%, we can calculate the ending balance for each investment after 25 years as follows:
Mutual fund: $19,407.10 ($10,000 x 1.09^10) = $86,231
ETF: $20,744.10 ($10,000 x 1.099^10) = $105,911
As you can see, after 25 years the ETF has outperformed the mutual fund by almost $20,000. This is almost 20% for a small initial 0.9% difference. This is because the mutual fund’s higher fees have compounded over time, reducing its overall performance. This example shows how mutual funds can underperform compared to other types of investment vehicles such as ETFs. The latter have lower fees over the long term.
This also goes to show that it would require finding a mutual fund manager that can outperform the market consistently by 1% for their fees to be worth your while. And such a consistent overperformance over 25 years is rarely ever seen. In fact, CNBC reported that 95% of fund managers underperform the market after 20 years. Finding the right one is akin to finding a needle in a haystack. It might be preferable to learn to invest yourself.
