Index Funds vs Mutual Funds

The Scene: When Amber resists replacing her Mutual Fund with an Index Fund, Dylan bets her that he can demonstrate ten ways that Index Funds are better. Dylan reads off his list while Amber makes lasagna.


Dylan flourished a piece of paper. “The number 10 reason why mutual funds always get destroyed by index funds.”

“Doing a countdown, are you?”

“Hey, I was almost a drama major.”

“I thought you were pursuing business?”

“That’s the great thing about dropping out of college after one semester: I was almost a lot of things. Now stop distracting me.” He flipped over my wooden salad bowl and patted out a drumroll. “Number 10: All costs of researching investments get passed onto you, whereas index funds require no research and therefore have no costs.”

Part of me wanted to see Dylan win this contest of ours, to show me that he really was savvier than he looked. A small part. A very small part. The other 99% of me despised losing bets under any circumstances. “That’s a totally lame reason. I want my fund managers doing their analysis. A research budget makes perfect sense. Not counting that one.”

“Oh?” Dylan didn’t look the least bit discouraged. That’s good. I like a guy with a bit of fight in him. “Next you’ll say that you want the funds advertising themselves too. Do you know that they also pass that expense on to you?”

My eyes bulged like a cartoon character’s. “You’ve got to be kidding me.”

“Nope.” He pointed to his list. “It’s called a 12b-1 fee. They can bill you up to 0.75% each year for their advertising costs.”

“0.75% of the profits?”

“Oh, no.” Dylan tapped on the bowl. “0.75% of your total account balance.”

“Their advertising costs should come out of their share, not mine.” I threw the carrots into the soup. “That can be your new number 10.”

“But I had it at number 3.”

“Then it sounds like you’d better come up with a new number 3.” I grabbed semolina flour for the noodles. “Either that or get busy building yourself a brick oven, because that’s how I like my pizza baked.”

Dylan cleared his throat. “Number 9, also under rule 12b-1, they can give out commissions and bill them to you, most often to whoever handles your 401(k) plan.”

“Doesn’t strike me as a big deal, but I’ll give that to you.” I turned down the soup to simmer. “Next.”

“Number 8, management fees. They charge you between 0.5% and 2% each year for handling your money.”

“Your index funds don’t have that?”

“Index funds require next to no management. Vanguard charges 0.05% in management fees for its S&P 500 fund. Mutual funds charge 10 to 40 times more.” He didn’t wait for my response before moving on. “Number 7 is a purchase fee paid to the fund when you buy-in. Which perfectly matches with number 6, which is a redemption fee of up to 6% when you sell.”

I was trying to knead the pasta dough but felt myself wanting to punch it. “That’s a lot of fees.”

“I’m just getting started. Number 5 is called a Sales Load, which is a fee paid to the broker when you buy or sell. This can be 5%, which means more or less the equivalent of a year’s worth of gains goes up in smoke.”

“Sounds like a load of—.”

“Sure does,” Dylan leaned over the counter and snatched a slice of red pepper. He bit into it with a Bugs Bunny grin of satisfaction.

“You’re sure enjoying yourself.”

Dylan shoved the rest of the pepper in his mouth. “What can I say? Being right is the greatest feeling in the world—well, other than…”

Time to change the subject! “So, you got any more fees up your sleeve?”

“They’re not up my sleeve. I didn’t make these babies up. I’m just the messenger.” He looked back at his paper and said, “Number 4, mutual funds are buying and selling constantly, and they bill the fund for each transaction.”

“As opposed to index funds that just buy and hold?”

“Precisely. But there’s an even bigger consequence to all the buying and selling, which brings me to number 2.”

“What happened to number 3?” I asked as I rolled out the dough.

“You made me use it for number 10, remember?”

“That just means you owe me a new number 3.”

“I’ll get to it, but right now I’m on number 2. Are you familiar with short-term and long-term capital gains?”

“No, what are they?”

Behind my back, Dylan sneaked into the cookie package again. “Well, say this ladyfinger is your initial investment.” Dylan lay the ladyfinger on the counter. “And your investment grew over time.” He pulled out a bunch more ladyfingers and made a pile out of them.

My hands were too covered in flour to fight him. I didn’t want to make an even bigger mess. “So those are my profits?” I asked, pointing to the pile.

“Exactly. Now, when you decide to sell, the government won’t tax you on your initial investment.” He pointed to the one ladyfinger. “But they will tax your profits. By how much? Well, that depends on how long you held the investment. If you held it over a year, they tax it only a little.” Dylan took one ladyfinger from the profits pile and bit off half of it.

“Hey!”

He ignored me and continued. “This is called a long-term capital gain. But if you held it for less than a year, they tax it at a far higher rate, called a short-term capital gain.” Dylan ate the rest of the ladyfinger.

“Did you really need my cookies to get that point across?”

“I get hungry watching you cook.”

As I sliced sheets of lasagna, I pondered this whole short-term versus long-term tax issue. “I don’t get the problem. I’ve held my mutual funds for over a year.”

“Mutual funds aren’t one entity, they’re a collection of stocks and the portfolio is constantly changing as the fund managers buy and sell. So they’re always taxed as short term capital gains.”

“That’s not the case with index funds?” Whatever part of me that had wanted Dylan to succeed had long since been silenced. Now I just wanted him to crash and burn.

“Nope, because the stocks are just sitting there. They’re not actively traded.”

“Even in my retirement account?” I asked.

“No. In your 401(k), you won’t be billed for short term gains.”

I pumped my fist in the air, “Yes!” At least I’d beat him on that one.

“Your gains will be taxed as regular income, which is even worse. Of course, the same is true for index funds or anything else in your 401(k). Did I mention I hate those?” Dylan grabbed another ladyfinger. “As long as we’re on taxes, I’ll give you a bonus one for another cookie.”

“Fine, but this is the last one, or I’m not making dessert!” At least I could still best him in the kitchen.

“Yes, ma’am.” Dylan held the ladyfinger between his fingers like a cigar. “You can even get taxed on profits that the fund made before you bought it. Say they’ve held Apple stock for the past 20 years, and the week after you buy the fund, they decide to finally unload that stock. You owe capital gains tax on those profits.”

“But I didn’t profit from it.”

“Doesn’t matter. You’re now a partner in the fund. So even if it goes down during the period you held it, you can get stuck with a massive tax bill.”

I sighed in exasperation. I was so done with this game. “What’s your number 1 reason?”

“Mutual fund managers make money whether the fund goes up or down. You could be losing your shirt while they’re off buying a new BMW. Your interests are not aligned.”

I didn’t know whether to be more frustrated with Dylan for being so right about how screwed I was getting with my mutual fund or with the broker for never telling me any of this stuff. “You’re still only at nine, by the way.” I still hoped to save face on the bet. “So you’d better get back to your research or start working on my pizza. I’ll take a Caesar salad on the side.”

“And a bottle of red wine?”

“White.” I laid lasagna noodles into my baking dish and spread a layer of ricotta over them. “By the way, how could you be so sure my fund would lose against the S&P 500 when it beat it so many years in a row?”

“Oh right, I forgot. I’ll call that number 3, the mutual fund bait and switch. A bank might have hundreds of funds, and statistically, they’re bound to have some that beat the S&P 500 a few years in a row. When it comes to advertising their featured funds each year to suckers who know little about the market, which do you think they highlight?”

I imagined my broker was the pepper mill as I cranked it over the cheese. “Obviously, the ones doing the best.”

“Right, so even though on average they’re getting killed by the index funds, in their publicity, they’re always highlighting the small portion of their portfolio succeeding.”

I handed him the pecorino and a grater. “But if a fund has a strong track record of success, shouldn’t it be a strong investment?”

“If only…” The pecorino fell like snow over the lasagna. “The fund that was doing well may have been tiny in previous years, but now that it’s featured, the amount of money it has under management goes through the roof. The bigger fund can’t slip in and out of opportunities like it did before.”

My body drooped like the roasted veggies I laid over the first layer of marinara sauce. “So the whole character of the fund changes?”

“Precisely. You may as well erase the history.”

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