I have a friend who, as he was becoming increasingly successful in his career, wisely decided to put some of his earnings away for a rainy day. Paying off the house, funding the kids’ college funds, and planning for an early retirement were at the top of his list.

Because computer programming is where his talents (and interests) lie, he decided to keep it simple by investing primarily in index funds. He did his homework, selected a few funds – small, medium, and large cap -- authorized automatic monthly withdrawals from his checking account and whammo! He had a long-term plan for financial success that requires little attention.

For most avid investors, that sounds like a yawner. Where’s the strategy? Where’s the excitement? Isn’t it not only more challenging, but more importantly – more profitable to invest in managed mutual funds? After all, index funds, by definition, mirror the overall stock market and its returns, while managed mutual funds attempt to outperform the market.

The short answer, surprisingly, is no. “We're so conditioned to believe that managed mutual funds, and the professionals who run them, are the best way to invest. Not true!” says Bob Adams, an InvestEd instructor and Associate Director for BetterInvesting's Puget Sound Chapter in Seattle, Wash.

What’s the issue with managed mutual funds? Fees – which, in a trickle-down effect, take a huge chunk out of the bottom line. “Historically, index funds outperform managed mutual funds,” Bob says.

Who’d have thought that something so seemingly small could make such a big difference? The difference is big – big enough that it could mean the difference between (fast-forward to your expected retirement date) sunning yourself on a white sand beach or a few more years at the office.

Small Fees, Big Difference
Whenever possible – and I make a conscious effort to make sure that that’s most of the time – I don’t pay fees. Little fees on everyday purchases add up big. That $2 fee charged for withdrawing money from an ATM that doesn’t belong to your bank? That’s 10 percent on a $20 withdrawal. That service fee for buying movie tickets before I get to the theatre? That extra $1 is a 10 percent fee on a $10 ticket; 20 percent on the matinee price of $5. While the advertisement for movietickets.com implies that my movie of choice could be sold out when I get there (and aims to instill panic at the mere possibility), it hasn’t happened to me yet. I’ll take my chances.

The same theory applies – and on a much larger scale – when you’re selecting mutual funds. “If, today, you invested $10,000 in a managed mutual fund that provides a return of 12 percent for the next 40 years, your portfolio would be worth $930,510,” Bob points out, “if no fees or expenses were charged.”

Fees – whether we’re talking managed mutual fund or index fund -- are a reality. What’s not set in stone are the funds we choose – and the fees that go along with them. “Managed mutual funds charge fees that average 1.5 percent,” Bob says. “If you reduce that 12 percent return to 10.5 percent, your portfolio value would drop to $542,614 – a difference of $387,896.”

And that’s before Uncle Sam’s cut. Taxes – a result of high turnover rates -- can undermine the returns an investor reaps on a managed mutual fund investment. “The turnover rate in a managed mutual fund can be 200 percent a year – meaning that the entire portfolio is replaced twice during the year,” Bob says.

“A high turnover rate means you will be paying taxes based on your regular rate – likely 28 percent or more – rather than the long-term capital gains rate of 15 percent. If you subtract the capital gains taxes and the fees paid over those 40 years, you will end up with $322,265 instead of the $930,510.”

Reality Check
At the time that my friend began investing in index funds, I was investing in managed mutual funds. It made sense to me. Though the managed funds charged higher fees, I figured that my portfolio would still outperform his. With a you-get-what-you-pay-for mindset, I assumed managed funds outperformed index funds. And, because I do follow the stock market, I figured my knowledge gave me a leg up. Was I being penny wise, but pound foolish?

“Most managed mutual funds underperform the market and you pay, on average, more than 4 percent per year in fees, commissions, and taxes,” Bob points out.  Are you aware, based on historical growth, $10,000 invested in an index fund for forty years may grow, based on long-term averages, to over $900,000? That same amount, invested in the average managed mutual fund after forty years, will be worth a little over $200,000 if 4 percent is used as a total cost in fees, commissions, and taxes. That’s the reality!”

But, he points out, it doesn’t have to be your reality. “Fees and turnover take a large slice out of your bottom line, so they are important,” Bob says. “If you don’t want to invest in individual stocks, which are likely to provide the greatest return, less expensive investment vehicles, such as index funds, are a great option. Low fees and very low turnover rates are their fortè.”

Comparing Apples to Apples
For starters, when you’re comparing and contrasting funds, Bob suggests the fund analyzer available at www.finra.org. “It’s an excellent tool if, for example, you want to compare three mutual funds over a period of years. It explains the costs.”

He also recommends that investors:

• Look for a low expense ratio (less than 1 percent) and low turnover ratio (well below 100 percent).
“The average index fund expense ratio of 0.18 percent results in a fee of 18 cents on each $100 in your portfolio, vs. $1.50 for the average managed mutual fund. And because of the low turnover, taxes paid on capital gains will be very low.”

• Choose only no-load funds (A 12b-1 fee – for advertising –  is limited to 0.25 percent. Load funds can charge up to 1.5 percent);

• Evaluate the return over a five-year period and check to see if the current fund manager actually managed the fund during that period.

I’m not suggesting that there’s no place for managed mutual funds in an investor's portfolio. What I am suggesting is that, whatever investments you choose, you choose them with your eyes wide open. When fees are taken into consideration, index funds often outperform managed funds long term -- but well-selected individual stocks will likely outperform them both.