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The truth about index investing

You may have heard debate about the relative merits of "passive" vs "active" investing. "Passive" describes investments such as exchange-traded funds (ETFs) that aim to match the returns of an index that tracks a given part of the market (also known as "indexing"). "Active" refers to funds that attempt to beat their benchmark index.

In fact, this debate is mostly a moot one. Indexing is far from passive, and active funds may not always deliver. Here are 5 things to keep in mind:

1. ETFs are generally cheaper, and can outperform active

ETFs cost less on average because it’s cheaper to track an index than to attempt to weed out the winning stocks and bonds from the losers. Lower operating and trading costs are passed on to you, the investor.

The savings can be significant. iShares ETFs, for example, are 1/3 the cost of a typical mutual fund1. ETFs are also more generally tax-efficient: the average tax cost for iShares ETFs is half that of active mutual funds2.

Lower costs can really add up over time and have a direct impact on performance. Actively managed mutual funds have to first overcome higher costs, making it even harder to beat the market. In fact, iShares Core ETFs have outperformed more than 75% of their mutual fund peers on average over the past five years3.

2. Investors can use ETFs to access nearly any market

With over 2,000 ETFs on the market4, investors can use ETFs for almost any investing need: stocks, bonds, commodities, specific sectors, countries or regions.

There are also ETFs that seek to deliver specific outcomes, like generating income or reducing risk. And factor, or "smart beta," ETFs provide a cost-effective way to invest in, say, value or growth companies, similar to a value or growth mutual fund.

3. Under the hood, every ETF is unique

Two different ETFs with similar names are like fraternal twins – close, but with surprising differences. If you’re looking at multiple ETFs with similar descriptions, take a closer look at their performance over time, annual expenses, tracking accuracy, tax costs, trading costs, and other characteristics to find the right choice for you.

4. ETFs have real-life portfolio managers who work to ensure the ETF tracks its index efficiently

ETFs are not managed by machines, but by flesh-and-blood portfolio managers, who update holdings as the fund’s index changes and monitor the portfolio to make sure it tracks its index efficiently. Moreover, while many ETF structures are more tax-efficient than mutual fund structures, the choices the fund manager makes can influence how tax efficient an ETF actually is.

5. "Passive" funds don’t equal passive investing

As an investor, you can be as active or hands-off in managing your portfolio as you choose to be – whether you use ETFs, mutual funds, or both. Ultimately, any investing decision you make is an active one – including the decision to invest in so-called passive funds.