An Exchange-Traded Fund (ETF) is a security that tracks an index, commodity, or basket of goods like an index fund but trades throughout the day like a stock. ETFs that passively track market indexes are popular with index investors because of their low expense ratios and trading flexibility. ETFs are purchased on an exchange using a brokerage account.
Simple math tells us that the average mutual fund investor earns a return equal to the market return minus any expenses incurred. An actively-managed mutual fund must endure numerous debilitating costs while attempting to beat a market index. Administrative, management, and marketing costs result in average expense ratios of 1.5%, transaction costs add another 0.85%, and the opportunity cost of holding an average of 8% cash reserves adds 0.40% (assuming a 5% equity risk premium).1 The result: average total annual expenses of 2.75%.
Index funds don’t require highly-paid analysts or stock pickers, they minimize annual fund turnover, and they stay 100% invested in the index (no need for cash reserves). The average total annual expenses of the index funds that we recommend are less than 0.35%.
The chart below shows the devastating effect of this difference in expenses over a 50-year time horizon, assuming an initial investment of $10,000 and an annual market return of 8%. When it comes to active management, the guy who gets paid is clearly not the investor. As Fred Schwed famously asked in his 1940 book title, “Where are the Customers’ Yachts?”
For those who know that they should invest in index funds but can’t resist the urge to be an “active” participant in the market, we’d recommend setting aside a small percentage of your portfolio (10% or less) to pursue active strategies. Keep this money separate from your risk-appropriate, strategically allocated portfolio, and decide beforehand that when the money’s gone, it’s game over.