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 decide which ones are 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 “expertise”. The default answer for most investors, certainly for those just starting, should be to own “the market” via passive index ETFs—specifically your country’s main stock market index. The index is a curated list of stocks selected to represent the overall market. The most common example in the US is the S&P 500 Index. In Canada, it’s the TSX Composite Index.

Why own a passive index ETF rather than the alternatives? 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 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, 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 long-term.
• These companies are typically broadly diversified across all economic sectors, making your investment more resistant to sector-specific setbacks.
• Over the long term, 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 sell your investments at any time for fair market value.
• Passive index ETFs have very low management fees compared to all the alternatives (often less than 0.1% per year).
• You can review their performance history and characteristics over many decades.
• They pay tax-advantaged ongoing dividends that can either be reinvested (to compound further) or used for ongoing living expenses (i.e. during retirement).

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

Passive Index Mutual Funds

How do ETFs compare to mutual funds? Since ETFs started appearing in the early 2000s, they’ve taken an ever-increasing share of the investment market, and with good reason. ETFs usually outperform traditional, actively managed mutual funds while charging substantially lower fees. To remain competitive, 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 high-quality 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 0.5% less annually, that represents having 15% less money over 30 years.

The only possible advantages of mutual funds 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), then obviously, for smaller contributions (e.g. less than $2,000), those transaction fees represent a large percentage of your investment. 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. Both theoretical downsides of ETFs are usually easy to work around with some planning. The main exception would be when you’re locked into an employer-sponsored retirement plan that offers limited investment choices.

At worst, if you have ETF transaction costs, you can accumulate shares of a passive index mutual fund, then switch that money to the equivalent 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 passive 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, even if you don’t sell (because of internal portfolio turnover). ETFs only generate taxable capital gains when you sell.

In short, there’s usually no reason to prefer passive index mutual funds over passive index ETFs, but there are several reasons to choose ETFs.

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 does. On average, mutual funds will have returns in the mid-to-high single digits, so these fees often represent a quarter of the total annual returns—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 hosed 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 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.

Active mutual funds also don’t reduce the downside risk 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 wanted to sell, to whom would they sell? Billion-dollar funds can’t move to 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 small 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 (the typical fund’s management 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. Much more critical is worse-case long-term returns, 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, blue chip stocks with decent dividends can often be a better way to provide that same steady income stream of bonds while still providing long-term growth. The volatility of a stock is unimportant if you can live off the dividends indefinitely and never need 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 Source #1: Financial Media

The standard TV (or YouTube) sound-bite stock recommendation has a few flaws. First, they tend to be predictions based on a set of beliefs or information that you don’t have access to. So 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 if someone makes a high-quality recommendation, what happens when there’s adversity in the markets? 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).

Dubious Source #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 100× your money, 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’s such a sure bet, why not exploit it completely 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.

Solid Source #1: High-Quality Investment Newsletters

Some professional, reputable businesses have paid newsletters where they make good 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 win × win rate %) – (size of average loss × loss rate %).

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

Solid Source #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 mainly 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 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 and 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.

But to succeed, you need to be strategic 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.

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. 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 takes a few minutes a month. If you choose to trade individual stocks, compare your performance to the index—if you’re not beating the index long-term, you’re not spending your time profitably.

Alternate Investments

For most people, investing in the stock market is the safest, simplest, and most predictable way to grow your long-term investments. However, you could choose some additional assets to complement that core.

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 only 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 and require no ongoing maintenance or risk of unruly 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 predict it will be superior to fiat paper money in the long term. But, before committing too much, 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 medium of exchange) 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. A 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 a 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).

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, and I expect most of them to disappear within a decade.

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, 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, long-term demand. For example, rare art and coins have centuries of interest. More recently, things like sports cards, Magic the Gathering, vintage video games, and Lego have demonstrated surprising longevity.

Key Points

• The market index is a reasonable benchmark to judge your portfolio—if you can’t beat it, you should own it.
• Bonds are counterproductive and are a performance drag in long-term portfolios.
• The market index will outperform most actively managed funds over the long term because they don’t outperform their fees.
• Fees are one of the most underappreciated and most avoidable costs of investing.
• Passive index ETFs are the lowest-cost way to own the market index, except in small accounts with transaction fees.
• 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.