Indexed Funds and ETFs vs. Actively Managed Funds - dummies

Indexed Funds and ETFs vs. Actively Managed Funds

By Russell Wild

Indexed funds (such as Exchange-Traded Funds and mutual funds) are safer and easier than actively managed funds. They also make more money over the long-run.

One study, done in 2010 by Wharton finance professor Robert F. Stambaugh and University of Chicago finance professor Lubos Pastor, looked back over 23 years of data. The conclusion: Actively managed funds have trailed, and will likely continue to trail, their indexed counterparts (whether mutual funds or ETFs) by nearly 1 percent a year.

That may not seem like a big deal, but compounded over time, 1 percent a year can be HUGE.

Let’s plug in a few numbers. An initial investment of $100,000 earning, say, 7 percent a year, would be worth $386,968 after 20 years. An initial investment of $100,000 earning 8 percent for 20 years would be worth $466,096. That’s $79,128 extra in your pocket, all things being equal, if you invest in index funds.

And if that investment were held in a taxable account, the figure would likely be much higher after you account for taxes. (Taxes on actively managed funds can be considerably higher than those on index funds.)

Moving from the world of academia and theory to the real world, let’s look at that very first ETF introduced in the United States, the SPDR S&P 500 (SPY). Since inception in January 1993, that fund has enjoyed an average annual return of 8.26 percent — not bad, considering that it survived two very serious bear markets (2000–2002 and 2008–2009). Very few actively managed funds can match that record.

By the way, SPY, as well as it has performed, has several flaws that make it far from a great first choice of ETF for most portfolios. But despite its flaws, SPY remains by far the largest ETF on the market, with total assets of $90 billion.

The largest fund of any kind is the PIMCO Total Return mutual fund [PTTRX], with total net assets of $136 billion. In terms of number of shares traded daily, nothing even comes close to SPY.