The truth about index investing

Funds that track an index are often described as “passive”, distinguishing them from actively managed funds, which aim to beat the market. “Passive” funds (which includes index mutual funds and the vast majority of ETFs) aim to track a given index, and replicate the returns that it achieves.

However, don’t take the shorthand to mean that investors who go the “passive” route are slacking on their portfolios – or their returns. Here are some of the facts to keep in mind when researching ETFs:

1.) ETFs have portfolio managers, and they work hard behind the scenes to make sure an ETF tracks its index efficiently.
Active fund managers work hard to achieve their fund’s investment objective, and for passive fund managers it’s just the same. The target index provides more of a roadmap, but fund managers still have to monitor for potential risks and update holdings as the fund’s index changes over time. Moreover, ETFs are structured to be particularly tax-efficient for investors, but the choices the fund manager makes can influence exactly how efficient they are.

2.) Investors can use ETFs to access nearly any market
Active mutual funds may have had a head start, but at this point there are over 2,000 ETFs on the market 1. Investors have their choice of using ETFs to invest in stocks, bonds, commodities, single sectors, and countries or regions, with both extremely targeted and extremely broad exposures. Investors can even choose ETFs that are seeking to deliver specific outcomes, like generating income or reducing risk. Another option is factor or smart beta ETFs, which follow indexes that are constructed to ‘tilt’ towards familiar style factors like value or growth. Under the right market conditions, these funds seek to potentially harness some of the market-beating potential of active funds with the ease of access and lower cost of passive funds.

3.) ETFs can outperform active management
Generally ETFs seek to track, rather than beat, their benchmarks after costs. But they often can end up outperforming active funds in the long run, due to their lower costs. ETFs cost less because there are fewer operational costs when tracking an index, and there is generally lower portfolio turnover, as indexes tend to change less frequently than active managers adjust their holdings in pursuit of outperformance.

These cost differences can be dramatic, and they add up over time. iShares ETFs, for example, are on average 1/3 the cost of a typical mutual fund 2. Additionally, due to their structure, ETFs may generally be more tax-efficient than mutual funds, so the average iShares ETF is also half the tax cost of the average active mutual fund 3. Taken together and compounded over time, these savings start to add up. And they make it harder for active funds to outperform, since they have to cover these costs to investors before they can post returns. The result is that iShares Core ETFs have outperformed more than 80% of their mutual fund peers on average over the past five years 4.

4) Under the hood, every ETF is unique
Two different ETFs tracking the same or similar indexes are like fraternal twins – definitely strong similarities, but there can be surprising differences, too. Two ETFs might have similar-sounding names or goals, but if you’re considering both, you’ll want to take a closer look at the investment strategy, annual expenses, tracking error, tax efficiency, bid/ask spreads and yield to find the right choice for you and your investment goals.

5). Investors actively manage their portfolios - whether they use ETFs, mutual funds, or both.
The key to remember is that investors have agency over the direction of their portfolios, and any investing decision made is an active one – including the decision to go passive.