Pop Culture Finance wants you to believe that the best type of investment is an index fund because the fees are lowest. An index fund tracks and performs just like a particular stock index. For example, if you have an index fund that tracks the S&P 500, it will perform just like the S&P 500. The other option is an actively managed mutual fund where there is a money manager actively managing the mutual fund. As a result, the fees are higher as opposed to the index fund that just tracks an index.
Morningstar reports that investors sold 207.3 billion from actively managed funds while shifting 413.8 billion into index funds. So what is the big deal?
It all comes down to Beta. Now, bear with me on this – it is easy to understand. Beta measures the risk of a mutual fund. A beta of 1 means you are taking the identical risk of the stock market. A beta of less than 1 means you are taking less risk and a beta greater than 1 means you are taking more risk.
Since index funds are tracking a stock index by definition they are at least a beta of 1. Whereas actively managed funds can have betas that are much lower than 1.
Why would you want to increase your risk by moving from a lower beta actively managed fund to a higher beta index fund when the market looks like it is possibly changing directions and heading into a bear market?
There is a time for index funds when taking risk in the stock market makes sense and there is time to be invested in low beta mutual funds when risk is high. Presently and the last 15 months or so has not sense to jump out of something that is designed to handle risk into full on risk.
The mutual fund industry has unfortunately convinced investors that paying the lowest fees is the best strategy and villainized mutual funds that charge higher fees. Be careful not to drink the Kool-Aid. There is a cost and it is called higher risk and higher possibility of loss!!