What is an ETF and Why You Need to Invest in Them

People ask me whether they should invest in active funds or passive funds. The answer is simple: Passive! Active manager fees are higher and performance usually trails the market, which is why you should invest in ETFs. What is an ETF, you ask?

What is an ETF?

ETF stands for Exchange-Traded Fund. They’re funds, meaning they own many different stocks, diversifying risk. They’re exchange-traded, which means you can buy and sell anytime the market is open, unlike mutual funds. And they track indices, which means the fees are much lower than active investments, which is why they usually outperform active investors.

ETFs Outperform Mutual Funds

According to this USA Today article, 2/3rds of active managers underperformed the SPX (S&P 500) in 2015. This Business Insider article shows similar underperformance up to the middle of 2016. Full year 2016 should be similar or worse than that because many managers were underweight financials and were caught off-guard from the Trump win and subsequent rise in interest rates.

Note that I lump index funds and index ETFs together, but I prefer ETFs because they’re more tax efficient, which is discussed in greater detail below.

The whole point of paying an active manager is to generate returns above what you could get from the market alone. You don’t pay somebody to make worse tacos than you could make yourself. Well, you do; it’s called Taco Bell, but what you’re paying for there is convenience and an explosive bowel movement.

What is Alpha?

In the world of finance, the return above the market return is called “alpha” while the market return is called “beta”. This is why active managers talk about generating alpha, but as the stats show, they rarely do.

Why Do Active Managers Underperform?

The problem with active management is it’s very difficult to beat the index, especially when you’re dealing with a large amount of assets. A manager running a $100bn mutual fund wants to beat the market, but he can only focus on the largest companies because small stocks are too small to move the needle. But large stocks are widely covered, so his ability to find any mis-pricing is limited. Another issue is he is benchmarked to the SPX. Managers don’t get much for outperforming their benchmark, but they do get fired for underperforming by a lot. This leads to “closet indexing”, which is when an active manager mirrors the SPX to keep his job.

This is a misalignment of incentives because the manager is incentivized to stay close enough to the index to collect fees and not get fired, instead of generating superior returns, which is what he should be trying to accomplish.

Why You Should Invest in ETFs

So we’ve established that active managers typically underperform the market. Part of the underperformance is due to management fees since performance is discussed net of fees. According to this Morningstar study, active managers on average charge 0.64%, or 64bps, to manage your money. Since 1988, the total return for the SPX is 12% annually, which includes reinvestment of dividends. The manager is basically charging 5% of the annual return. 64bps doesn’t sound like much (it’s less than 1%), but over time, it can add up. To put it into perspective, many ETFs charge 5bps, so the active manager is charging 13x more!

For example, let’s say Investor #1 invested $10,000 in the SPX in 1988 through an ETF, generating a 12% annual return. Investor #2 invested in an active manager that also generated 12% on a gross basis, or 11% net of fees. Today, Investor #1 would have $267,000, vs. $206,000 for Investor #2, or 30% more!

what is an etf and how your returns varies depending on fees

Mutual Funds Are Not Tax Efficient

Another issue with investing with an active manager is the tax leakage. An active manager should be trying to beat the market, so he’s in the market buying and selling stocks on a regular basis. If he owns the stock for more than a year and sells, he incurs long-term capital gains, but the gain will be taxed as ordinary income if he holds it for less than a year. If you owned this fund for 20 years and never sold, you’ll still pay taxes on his trades every year because technically they’re your trades. Owning an ETF eliminates this problem. You don’t pay taxes on an ETF until you sell your position. Because you get to decide when to sell, you can take advantage of more favorable tax rates, such as holding for at least a year to get long-term capital gains.

ETF = Boring

I get it. ETFs are boring. You’re not going to be the center of attention at a dinner party when you talk about how your portfolio generated the market return (but at least you paid a minimal amount of fees!) I’m not advocating putting all your investments into index ETFs. What I’m suggesting is that you use index ETFs for your core holdings. With a beta generating asset in your portfolio, you can take more risk with your other assets. Like investing in company stock or a sector that you like. Or even an active manager you think is good. It’s with these riskier assets that you can use to generate alpha. If you’re thinking about investing on your own, this link discusses how you can outperform hedge funds.

Front-End Load or Back-End Load?

So you’ve decided to go ahead and invest in a mutual fund. Do you go with ones with a front-end load or back-end load? Are you kidding me? Not only are you paying for underperformance from an active manager, but they want to charge a sales commission when you buy the fund or when you sell it?

An Active Manager Doesn’t Recommend Active Management?

I can explain. First, I’m a market neutral investor. Because I’m market neutral, I hedge out the beta, which leaves pure alpha. Therefore, I don’t benchmark to an index, but instead focus on absolute returns. Second, my comp is driven almost entirely by P&L. If I don’t generate returns, I don’t get paid. So my interests are aligned with my investors. Finally, my clients are usually institutional investors, so tax leakage is not a concern because they are exempt from capital gains.

I should note that many institutional investors are pushing back on hedge fund fees, as recent performance doesn’t justify 2 and 20. It’s called 2 and 20 because there’s a 2% management fee and 20% of profits. That being said, it highlights how even sophisticated investors believe high fees can eat into profits.

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