For as long as there have been Individual Retirement Accounts (IRAs) and 401(k) plans, mutual funds have been a mainstay for retirement plans, and for good reason. They offer professional management and instant diversification, which is more than what most investors can do effectively on their own when investing in stocks and bonds. However, with the advent of index funds and exchange-traded funds (ETFs), investors have more to consider in determining whether retirement mutual funds are still a good investment option for their portfolios.
Mutual funds have always played a critical role for investors seeking a balanced and diversified approach to long-term investing. Most investors don’t have the sufficient capital to buy a portfolio of individual stocks and bonds for adequate diversification. The core concept of mutual funds is the pooling of money from thousands of investors, enabling them to spread the risk by investing in dozens or hundreds of securities. Investors who lack the time, inclination and expertise to research stocks can rely on a professional portfolio manager to identify, select and monitor the portfolio’s holdings, making the difficult buy and sell decisions along the way. Because there are thousands of mutual funds from which to choose, investors have the ability to combine mutual funds with varying portfolios and investment objectives to fit their asset allocation strategy.
Except for the fact that there are more of them offered in greater varieties, mutual funds haven’t changed much over the decades. However, what has changed is the introduction of investment alternatives, such as index funds and ETFs, which have revealed the drawbacks of owning actively managed mutual funds in a retirement plan.
Underperformance: Over a 10-year period between 2005 and 2014, only one equity mutual fund class — U.S. Mid-Value funds — has managed to outperform its benchmark index. All other equity fund classes have consistently underperformed their benchmark indexes. On average, equity passive funds outperformed active funds by a margin of 0.65.
High Costs: The inability of active funds to outperform the indexes or their passive counterparts raises the question as to whether their higher fees are warranted. The average expense ratio for active funds is 1.43%, compared to 0.25% for passive funds.
Mutual funds can also include other expenses, such as sales loads and embedded costs for trading and research. The more actively managed that a fund is, based on portfolio turnover, the higher these expenses can range. High portfolio turnover can also result in more taxable activities, which can eat into the fund’s overall performance. All of these expenses can total 2 to 3% or more annually, which is a high hurdle for most fund managers to overcome in trying to outperform an index. Just a 0.5% difference in fund expenses can negatively impact a retirement plan by tens of thousands of dollars over the long term.
Passively managed index funds and ETFs do a much better job of matching the performance of the market, because their portfolios reflect the market. Their portfolios are designed to replicate a particular index. There is little need to make buying and selling decisions, except to maintain the proper weighting of a portfolio. This makes management fees minimal and more tax efficient, and there are no trading or research costs. Active mutual funds can still play a role in retirement portfolios for investors who want to inject additional risk or gain exposure to a particular sector, in order to generate higher returns. However, the same thing can be achieved by using an asset- or sector-specific ETF or index fund at a fraction of the cost.