The Advantage of Indexed Exchange-Traded Funds - dummies

The Advantage of Indexed Exchange-Traded Funds

By Russell Wild

The superior returns of indexed mutual funds and exchange-traded funds (ETFs) over actively managed funds have had much to do with the popularity of ETFs to date. Index funds (which buy and hold a fixed collection of stocks or bonds) consistently outperform actively managed funds.

One study done by Fulcrum Financial tracked mutual fund performance over ten years and found that 81 percent of value funds underperformed the indexes, as did 63 percent of growth funds. And that is just one of many, many studies that present similar results.

Here are some reasons that index funds (both mutual funds and ETFs) are hard to beat:

  • They typically carry much lower management fees, sales loads, or redemption charges.

  • Hidden costs — trading costs and spread costs — are much lower when turnover is low.

  • They don’t have cash sitting around idle (as the manager waits for what he thinks is the right time to enter the market).

  • They are more — sometimes much more — tax efficient.

  • They are more “transparent” — you know exactly what securities you are investing in.

Perhaps the greatest testament to the success of index funds is how many allegedly actively managed funds are actually index funds in (a very expensive) disguise.

According to a report in Investment News, a newspaper for financial advisers, the number of actively managed stock funds that are closet index funds has tripled over the past several years. As a result, many investors are paying high (active) management fees for investment results that could be achieved with low-cost ETFs.