Why Passively Managed, Low-Fee Index Funds Are Ideal Assets

Learn to choose the most appropriate investment assets for you, rather than your bank, among stocks, bonds, ETFs, mutual funds, and crypto.

As investors, we have an unbelievable selection of potential assets. For example, in the US alone, there are 6,000+ different stocks (source), 7,300+ mutual funds (source), and 2,700+ ETFs (source). How can we realistically choose which is best for us?

Passive Index ETFs (The Benchmark to Beat)

I think financial institutions and advisors, and the financial media industry in general, overcomplicate things—which is unsurprising since they are trying to sell you reliance upon their products and services. Instead, the default answer for most investors, certainly for those just starting, should be to keep things as simple as possible and own “the overall market” via passive index ETFs—specifically your country’s overall stock market index. For example, this would typically mean the S&P 500 Index in the US. In Canada, it’s the TSX Composite Index.

What is a passive index ETF? A stock market index is a curated list of the largest publicly traded companies (stocks) selected to represent the overall market. An ETF is a fund you can invest in via your local financial institution (similar but superior to a mutual fund) that seeks to replicate the index’s performance by owning the same underlying assets. Passive means that the fund does not make any discretionary decisions to predict or time the market but passively follows its target index.

In short, passive index ETFs give us a single asset we can buy, representing partial ownership (via stocks) in hundreds of the largest companies in your country. As these companies grow and prosper, you benefit and participate in that growth.

Why own a passive index ETF rather than the alternatives? The primary reason is performance. It’s unlikely your portfolio has outperformed the index over the past 10+ years. Go ahead and check—I think you’ll be surprised. Over the longer term, the market index represents a surprisingly high bar to overcome—certainly much better than “average”. For reference, the compound annualized rate of return (including dividends) of the S&P 500 has been 9.5%+ (data) since 1928, and the TSX Composite has returned 8.0%+ (data, data) since 1945.

Besides stellar performance, there are several additional benefits to owning the index:

• It holds prominent, high-quality, well-established companies and, therefore, will be very safe to hold over the long term.
• These companies are broadly diversified across all economic sectors, making your investment more resistant to sector-specific challenges.
• The companies pay tax-advantaged ongoing dividends that can either be reinvested (to compound further) or used for ongoing living expenses (i.e. during retirement).
• You benefit from a natural survivorship bias—meaning struggling companies are regularly dropped from the index and replaced by stronger ones long before they risk bankruptcy.
• You can easily own the index via highly liquid ETFs, meaning you can quickly buy or sell your investments at any time for fair market value.
• Passive index ETFs have very low overhead costs (management fees) compared to all the alternatives (often less than 0.1% per year).
• You can quickly review the historical performance and volatility of the index over many decades, far longer than most other investments.

Passive index ETFs should be the default choice for most investors and the ideal benchmark for comparing other assets because of their strong performance, simplicity, and low risk. Simple is usually better than complicated. If you can’t beat ’em, why not join ’em?

Passive Index Mutual Funds

How do ETFs compare to mutual funds? Very favourably. Since ETFs started appearing in the early 2000s, they’ve taken an ever-increasing share of the investment market, and with good reason. Since their inception, passive index ETFs have handily outperformed traditional, actively managed mutual funds while charging substantially lower fees. In response, financial institutions created lower-cost passive mutual funds that track the same indexes. You can usually recognize a passive mutual fund because it will have Index in the name.

The problem is that passive mutual funds usually still have fees 10× those of the equivalent ETF (e.g. 0.5% vs. 0.05%). So, what’s the point? They track the same index (i.e. hold the same assets), so their returns will be no better. What benefit are you gaining to compensate for those extra fees? And before you idly dismiss earning half a percent less annually, that translates to having 15% less money over 30 years.

The only possible advantages of mutual funds over ETFs are a lack of commissions and support for fractional shares. For example, if you pay $9.99 per ETF transaction (as you will with many banks), those transaction fees represent an unreasonably large cost for smaller contributions (e.g. less than $2,000). Similarly, if you’re dollar-cost averaging monthly or every paycheque, being required to buy whole shares of an ETF (which cost dozens or hundreds of dollars per share) could be very limiting.

Fortunately, many discount brokerages/robo-advisors now offer $0 commissions and allow buying fractional shares of ETFs. Some banks also offer no-fee ETF transactions. So, both theoretical downsides of ETFs are usually easy to work around. The main exception would be when you’re locked into an employer-sponsored retirement plan that offers limited investment choices.

At worst, if you pay ETF transaction commissions, you can accumulate shares of a passive index mutual fund, then switch that money to an appropriate ETF once your position is big enough to make a difference (i.e. the amount saved in management fees is less than the transaction cost of switching).

Besides fees, the other disadvantages of mutual funds are that they may require larger minimum contributions (e.g. $500) and are less tax efficient (if you’re investing outside a tax-sheltered account). Because of their structure under tax law, mutual funds typically generate ongoing taxable capital gains while you hold them (because of internal portfolio turnover). ETFs only generate taxable capital gains when you sell.

In short, passive index ETFs are almost always superior to passive mutual funds.

Active Mutual Funds & Active ETFs

Actively managed funds (as opposed to passive funds that merely track an index) are more proactive in trying to outperform the market. They pay a team of highly educated people to analyze and predict the markets and somehow move billions of dollars around nimbly enough to outperform other funds. The cost of this management (MER) is usually 1.0%–2.5% per year, depending on the fund and where you live (the US is cheaper, but Canada is especially expensive [data, data]). This management fee is ongoing, regardless of how well or poorly the fund performs. On average, mutual funds will have returns in the mid-to-high single digits, meaning these fees can represent a quarter of their average annual returns—unreasonably high. I’d happily manage your money if I could take a quarter of your returns.

Worse, Canadian banks have multiple versions (series) of the same mutual fund targeting different investor profiles. The fund series designed for self-directed or large-account investors will have fees at the low end of the fee range. The series designed for the typical investor will have fees closer to the high end of the range—yes, the average investor gets soaked again.

The most egregious type of mutual fund is fund-of-funds. Often, these are target-retirement-year portfolios designed to automatically adjust the volatility level of your portfolio as you approach retirement. The cost of these managed portfolios is “only” an additional 0.5% per year, above and beyond the already high fees of the individual underlying mutual funds.

The dirty little secret of actively managed mutual funds is that they don’t outperform their fees. For example, >90% of mutual funds underperform their benchmark index over 15 years and >95% over 20 years. Even a 5-star rating from Morningstar just means that a fund has outperformed on a relative basis (compared to its peers)—it’s not a comparison to an absolute benchmark like the S&P 500 Index, to which the underperformance rates are even worse.

Active mutual funds also don’t reduce the downside volatility of your portfolio. Each mutual fund has a self-imposed mandate to maintain a particular mix of assets, regardless of whether they know the market is about to drop. And even if they weren’t constrained, to whom would they sell their shares? Billion-dollar funds can’t simply sell everything and move into cash—they’re just too big. Ever notice that mutual funds don’t report drawdown statistics (their largest % drops in value)? If they actually helped protect your downside, don’t you think they would advertise that?

In short, mutual funds are good for banks, not you. There’s likely no reason for you to hold active mutual funds. Passive mutual funds are preferable to active ones, but only when passive ETFs are unavailable. A single index ETF (or potentially a handful for geographic diversification) will likely meet your existing portfolio’s goals with less complexity, better performance, and lower fees.

Actively managed ETFs are usually no better than active mutual funds because they suffer from all the same limitations. Whatever benefit active funds purport to have is not reflected in their performance. Passive funds have proven to perform better over the long term. Remember that the cost of those fees compounds over time—earning 2% less per year (because you’re paying unnecessary fees) means having half as much money after 30–35 years.

Bonds

Owning a passive index ETF means investing 100% in stocks. So, what about bonds or fixed income more broadly? The primary justification for bonds is that they’re less volatile than stocks and are often negatively correlated (move up when stocks move down). Thus, when combined with stocks, bonds ought to reduce the volatility and drawdowns of your portfolio.

The problem is that bonds will usually underperform stocks over the medium to long term—the longer the timeframe, the higher the likelihood of underperforming.

Average Rolling Inflation-Adjusted Returns (1928–2022) (data)

Yes, bonds will reduce short-term volatility, but that’s irrelevant if you’re a long-term investor. Worse-case long-term expected returns are much more critical, which bonds do not help with. Bonds will simply reduce your best, average, and worst-case long-term returns. As such, I don’t believe bonds have a place in long-term portfolios (>10 years).

Bonds can make sense if you have shorter-term needs for your money (e.g. a retiree) and need a steady income stream and capital preservation over returns. But even conservative model portfolios hold 40%–60% of stocks. The returns and inflation protection of stocks are too attractive to ignore.

As an alternative to bonds, large, financially sound, mature companies (i.e. blue chip stocks) with decent dividends (3%+) can often be a better way to provide the same steady income stream as bonds while still providing long-term growth. The day-to-day volatility of a stock is unimportant if you can live off the dividends indefinitely and, therefore, you are never forced to sell. This feature is why high-quality dividend-paying stocks are usually the favourites of the F.I.R.E. (Financial Independence Retire Early) crowd.

Individual Stocks

Investing in individual stocks can be profitable, but it is much more complicated than owning a passive basket of stocks like an index. The main problem is the millions of recommendations about which ones to buy. Recommendations get churned out by the boatload by the financial media or YouTube, but 99% of them are worth exactly what you paid for them—nothing. I like to call it invest-o-tainment.

Dubious Strategy #1: Financial Media

The standard TV (or YouTube) sound-bite stock recommendation has a few noticeable flaws. First, they tend to be predictions based on a set of beliefs or information that you don’t have access to. Why should I trust you and your predictions? Do you have an auditable track record demonstrating your superior stock picking? Many stock pundits, like Jim Cramer from Mad Money, have lousy track records (source, source, source). Second, when should I sell? What would change your mind about this investment? Buying is only half the trade. Third, why aren’t all the reasons you believe the stock is a good buy right now already priced in?

Even when someone makes a high-quality recommendation, what happens when there’s adversity in the overall markets or economy? Is it still appropriate to hold? It’s hard to have conviction in somebody else’s idea when they aren’t there to update it continually.

If you’re not paying for the product, you are the product. The financial media and YouTube content producers churn out new content daily, not because they have something novel to say but because they need to hold your attention to monetize your eyeballs.

A simple clue is to listen for weasel words like could. Could is a synonym for possible rather than likely. Yes, Bitcoin could triple in price by the end of the year (it could also drop by 90%). Tomorrow, you could get struck by a meteor or have a long-lost relative leave you a big bag of money. A prediction is meaningless without any probability attached (and believable evidence and reasoning to back it up).

Dubious Strategy #2: “Hot” Stock Tips

Perhaps it’s just me, but I often see ads for newsletters professing they have “discovered” the next Apple, Amazon, or Tesla. “Buy now and grow your money 100×, guaranteed! Chance of a lifetime, but you must act now! (Not an actual guarantee, past performance may not represent future performance...)”. An obvious question to ask is why they’re willing to share this golden, rare opportunity with you? If it were such a sure bet, why not hoard it and exploit it fully themselves?

“There are no get-rich-quick-schemes. Those are just someone else getting rich off you.” —Naval Ravikant

The problem with penny stocks or startup companies is that many things need to go right for them to succeed. Not only do they have to have a killer idea, but they must be logistically well-run and get lucky enough to have the market accept their product before they run out of money. Make no mistake: entrepreneurship is the key driver of innovation and growth in our economy, but it’s tough. There’s a reason venture capital firms make many bets—it’s impossible to predict which ones will succeed, even by professionals. Some of their bets will be profitable. A few will be wildly profitable. Most will fail. Betting on small, unknown companies has much in common with gambling or buying lottery tickets—you may strike it rich, but it’s improbable.

Dubious Strategy #3: Outsourcing Your Money To A Money Manager

Since we’ve been trained that investing is “too hard” for us to do ourselves, a thriving industry of independent portfolio managers who will invest your money for “just” 1%–1.25% per year has emerged. They will often invest your money into a selection of individual stocks, but it could also be other types of assets (e.g. mutual funds, ETFs, bonds, private equity).

The sales pitch is: we’ll do all the time-consuming drudgery of buying, selling, and monitoring your investments 24/7 so that you don’t have to. It sounds appealing, but the problem is it’s all invented work. Owning individual stocks is a lot of work, so don’t—why not just own a single asset (the index) instead? My question would be: what’s your performance (after fees) over the past 15 years compared to the index? How often have you beaten it, and by how much? How do your drawdowns compare? Like active mutual funds, I bet most money managers don’t outperform their fees (i.e. beat the index).

Our instinct is to search for someone to help with the challenges of managing our financial life, so focus on that instead. Having a financial professional help you create a long-term plan and understand the intricacies of your specific financial situation is extremely valuable. A licensed fee-only advisor can help you craft a holistic strategy to address your long-term financial and life goals for a flat one-time fee. The benefits are no conflict of interest (no incentives to invest according to their interests rather than yours) and no ongoing fees sapping your returns.

Your goal should be to manage your financial life and assets yourself. Seek out professional advice and guidance as needed, but don’t try to outsource it. Simpler is better. Confidence and trust in your finances can only come from understanding, which you’ll never get if you don’t do it yourself. Most people don’t need to pay someone to manage their investments for them unless, of course, you’re a multi-millionaire.

Solid Strategy #1: High-Quality Investment Newsletters

Some professional, reputable businesses write paid newsletters that make high-quality stock recommendations. My requirements for a newsletter are the following:

• They have a long, fully auditable track record of all their past recommendations (not just their winners).
• They trade in highly liquid investments (i.e. not stock options or penny stocks—it doesn’t matter what their recommendations’ advertised (theoretical) performance was if it was unachievable by their subscribers.
• They publish overall portfolio results from following their recommendations, reporting the expected annualized rate of return and the size and length of the worst drawdowns—not just a list of trades. It’s essential to understand if this was a strategy you could have stuck with in real-time or not (either due to boredom or stress). People vastly overestimate how big a drawdown they can tolerate before losing faith and quitting.
• They were ongoing (live) recommendations, not just back-tested results. Anyone can retroactively data mine good results with enough curve fitting.

Also, be careful about being seduced by high percentage winning trade rates—I’m very suspicious of anything above >65%. Remember that win rate is only part of the equation: profit = (size of average winner × win rate %) – (size of average loser × loss rate %).

Following a reputable newsletter is highly likely to outperform trying to stock-pick yourself. You’ll never be able to compete with the research departments and expertise of the experts (regardless of what Reddit says).

Solid Strategy #2: Technical Trading

Stock-picking is about comparing a company’s financials versus its current stock price to find companies you predict will outperform over the longer term. In contrast, technical trading is about anticipating or reacting to shorter-term price movements in the market, moving in and out trades regularly, and being agnostic of the specific asset owned and its underlying fundamentals. The logic is that an asset’s current and historical price tells you the overall consensus of all public information about an asset—thus, anything else is just idle speculation.

The most effective, enduring technical trading methods are based on momentum or trend-following. The reason is that markets exhibit an unusual characteristic called the momentum anomaly—meaning they often trend up or down further than they ought to if price movement was purely random (following the random walk hypothesis). Momentum is a ubiquitous feature of markets (likely due to emotional herding mentality) and thus is likely to persist as long as humans are trading in markets.

To succeed as a trader, you must be selective about how you trade. For example, day trading is foolish and wildly unprofitable for most who try because it’s improbable you can compete with high-frequency trading algorithms. Instead, leverage your advantages: (1) you’re small and can invest in opportunities too small for billion-dollar funds to bother with, and (2) you can be patient—you don’t have a corporate mandate expecting you to deliver profits every day or week.

To be profitable, expect trading to be dull and mechanical. As soon as your emotions get involved, you’ll make suboptimal decisions. If you’re looking for fun and an adrenaline rush you’ve already lost—go to Vegas instead. Trading will not make you instantly wealthy—nothing will, but it can outperform more passive investing if you put in the long-term work to become skilled.

For most investors, a basket of stocks (like an ETF) is preferable to investing in individual stocks. A simple investment strategy, like the ones I suggest here, only owns one (or a small handful) of funds and only takes a few minutes a month to manage. If you choose to trade individual stocks, remember to compare your performance to the overall index—if you’re not beating the index long-term, you’re not investing your time wisely.

Alternate Investments

For most people, investing in the stock market is the safest, simplest, and most predictable way to grow your long-term investment portfolio. However, once you’ve built up your core portfolio, you could choose to supplement it with some additional assets as diversification.

Real Estate

Owning your own house makes sense financially, at least compared to renting. Renting will always be more expensive than owning (if you compare the same property) because your landlord has the exact costs as you would, plus they want to get paid for their time. The only way for it to be otherwise is if your landlord is losing money (e.g. rent controlled). The mistake is comparing an 800 sqft apartment to a 2,500 sqft house—clearly, the house will be more expensive because you’re getting more. The most significant risk of owning a house is that if you live in an area with enormous boom/bust cycles in real estate and don’t intend to stay in the house for decades, you could have unfortunate timing on your transactions. The main financial downside of owning your home is you end up with substantial equity locked up in your house, which, during retirement, can only be accessed by downsizing or using a reverse mortgage.

Owning investment properties as rentals can be profitable. But the more you manage them yourself, the more work they require—the more you outsource, the less profitable it will be. If that’s how you want to spend your time, go for it. But it’s not for me. Owning investment properties has too much liquidity and timing risk for my tastes. I prefer investments I can sell in a few seconds, requiring no ongoing maintenance or risk of destructive tenants. For example, I’d rather own assets that invest in real estate than directly own investment properties.

Precious Metals

I like precious metals as investments and own some physical bars and coins. But, unlike active businesses, which will outpace inflation because they’re innovating and producing things people need, precious metals will not. They’re just dumb rocks. They should be considered stores of value rather than productive investments. They have marginal utility value and will largely trend towards the cost of production. As the cost of production (mining) increases, the value of your asset will increase—just hope they don’t find a way to mine asteroids profitably.

So, while physical precious metals can be a sensible part of a diversified portfolio, I don’t think they’re the right place to start. You’re not going to get rich owning precious metals.

Cryptocurrencies

I like Bitcoin as an investment and own some in self-custody because I believe it is superior to fiat paper money and can potentially replace it over the long term. But, before jumping on the crypto bandwagon, it’s essential to be clear on the risks.

The first risk of Bitcoin is people lose interest. As shown historically, anything can be money (a store of value) so long as there’s consensus. Bitcoin has several advantages over fiat money: it has a fixed supply (can’t be inflated), it’s digital (geographically borderless), and it’s seizure resistant. However, it does require an active, vibrant community to run and maintain it. Bitcoin has no intrinsic value other than what someone else will trade you in return. If the community withers and disappears, the demand (and value) of Bitcoin will, too.

The second risk of Bitcoin is the same as that of gold—redeemability. For example, what happens if the government outlaws owning Bitcoin (as previously done with gold) and prevents financial institutions or merchants from accepting it? Then what? You could have “millions” of dollars worth of Bitcoin but have no way to spend it. Your only choice would be to move to a jurisdiction that hasn’t outlawed it.

There will continue to be a risk of owning Bitcoin until enough governments tolerate it as a legitimate store of wealth (as some countries have tentatively started to do [example, example]).

The main challenge of Bitcoin is that it represents a risk to the government because Bitcoin usurps its monopoly on creating money. If people have an alternate currency that is a better store of value than their local currency, they’ll prefer it over that local currency. You can already see this in countries that have problems with hyperinflation. When someone gets paid in these countries, they immediately convert their currency into harder money that will retain its value (like the US$, gold, or Bitcoin). I fear that, while Bitcoin may indeed be better money, there are no guarantees that governments won’t try to crush it.

Other than Bitcoin, most other cryptocurrencies have little reason to exist. Most will likely dwindle and disappear within a decade as people and industry consolidate around Bitcoin.

Collectibles

I like collectibles and own a variety as investments. But, like real estate, they have a liquidity and disinterest risk—if other people aren’t interested in buying them from you, they have no value. There’s also a significant risk of fads, like Beanie Babies or Bored Apes NFTs. For example, most NFTs are probably, or will become, worthless. Having a thing with no utility value tied to the popular brand-of-the-day, which needs people to desire it, is problematic when there are millions of different variations of these things, all looking to fill that same niche. As a result, there’s little reason for any of them to have much value. The best way to invest in collectibles is to find things with sustained, long-term interest and, thus, probable long-term demand. For example, rare art and coins have centuries of interest. More recently, collectibles like sports cards, vintage Magic The Gathering and Pokémon cards, vintage video games, and Lego have demonstrated surprising longevity.

Key Points

• The stock market index is a reasonable benchmark to judge your portfolio—if you can’t beat it, you should own it.
• The index will outperform most actively managed mutual funds over the long term because mutual funds don’t outperform their relatively high fees.
• Passive index ETFs are the lowest-cost way to own the market index, except in small accounts with transaction fees.
• Bonds are counterproductive and are a performance drag in long-term portfolios.
• Fees are one of the most underappreciated and most avoidable costs of investing.
• Alternative investment assets can make sense as additional diversification after you’ve built a core foundation of liquid, high-quality, performant, boring assets.

Points to Ponder

• Is your portfolio keeping up with the market index? If not, why not? Should you own the index instead?
• Why do you own the investment you do? Did you choose them explicitly, or were they the default option presented by your financial advisor? Could you be doing better?
• Do you know how much you’re paying in fees/costs/overhead for your investments? What about as a percentage of your total returns?

Related Concepts

• Why Inflation Isn’t What You’ve Been Told and Why That Matters
• Why Aggressive Portfolios Are Usually Safer Than Conservative
• How to Time the Stock Market and When You Shouldn’t Bother

If you have comments, questions, or constructive feedback, you can contact us by email at questions@essentialsofinvesting.com.