Personal Finance

Why this strategy has been a boon to investors over the last decade

Key Points
  • Assets in "passive" choices — index mutual funds and exchange-traded funds, or ETFs — have quadrupled since 2010.
  • The median cost of these investments is less than half that of actively managed funds.
  • Their lower cost has had a ripple effect across the industry, which has been a positive for investors.

If you pay lower investment fees than you did a decade ago, you can probably thank the explosion of index-based funds.

Assets in such "passive" choices — index mutual funds and exchange-traded funds — have quadrupled since 2010, while traditional mutual funds have watched more money flow out than come in since 2015, according to investment research firm Morningstar. Although the reasons for the shift are varied, lower cost has been a big driver and a boon for investors.

"From an investor's point of view, the most meaningful effect [of the trend] is that it's brought fund fees under ever-more scrutiny," said Ben Johnson, global director of ETF research at Morningstar.

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"Investors are realizing that the idea of 'if you pay more, you get more' isn't necessarily true — and that the more you pay, the less you get in returns," Johnson said.

Passive investing, when it comes to index funds and ETFs, generally refers to the nature of how these choices work.

Instead of expert stock-pickers at the helm — as is the case with actively managed mutual funds — these funds each replicate an index, which could be broad-based or focused on a narrow segment of the market. And generally speaking, its performance will mirror that of the index it's tracking.

With actively managed mutual funds, on the other hand, gains or losses depend on the investment choices of the fund's managers.

While actively managed funds have been bleeding assets for five years, they nevertheless still dominate the fund universe with total assets of $12 trillion, up from $7.1 trillion a decade ago, according to Morningstar.

Index mutual funds hold roughly $4 trillion, up from under $1 trillion in 2010. Similarly, $4.1 trillion is invested in passively managed ETFs, up from $1 trillion in 2010. Among the small share of ETFs that include an active component, assets have gone to $94.8 billion from about $2.9 billion in the last decade.

There are some differences among the funds. For example, mutual funds — whether actively managed or the index version — can only be bought and sold once daily, after the market's 4 p.m. ET close. ETFs, on the other hand, trade throughout the day like stocks.

Investors are realizing that the idea of 'if you pay more, you get more' isn't necessarily true — and that the more you pay, the less you get in returns.
Ben Johnson
global director of ETF research at Morningstar

Also, because of their structure and how they trade, ETFs generate little in the way of capital gains. This makes them more tax-efficient than actively managed mutual funds, which pass along profits to shareholders in the form of capital gains, which are taxable.

The cost differential also is notable. As of last year, index funds came with a median expense ratio — the share of your assets taken yearly as compensation — of 0.44%. That figure for passive ETFs was 0.45% and for actively managed ETFs, 0.6%. (Median means half fall below, half above.)

In contrast, that median fee for actively managed mutual funds was 0.96% — more than double that of their passively managed brethren, although down from 1.17% in 2010.

"There's been pressure, and action taken, among [actively managed] competitors to prove the economics of their fund," said Johnson.

The lower fees on index-based funds have affected the financial advice business, as well, with many advisors using ETFs or index funds to build client portfolios at a lower cost. While the average charge from advisors hovers around 1% of assets they're managing for you, that fee increasingly includes things beyond investment management, such as estate planning, tax strategies and retirement-income planning.

"The price still coalesces around 1%, but the level of service and involvement in a client's life has expanded and will continue to expand," said CFP Mike Hennessy, founder and CEO of Harbor Crest Wealth Advisors in Fort Lauderdale, Florida.

"Clients can get investments for [0.25% or 0.5%]," said Hennessy. "There's simply no reason to pay someone 1% or 1.5% for that."

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Your investment fees matter because they take a bite out of money that otherwise would be in your account to continue growing. The bigger the yearly expense, the bigger the hit to your earnings over time.

Say you invested $100,000 for 20 years and your annual return was 4%. If you paid 0.25% yearly, you'd have close to $210,000 at the end of those two decades.

In contrast, if you paid 1% a year, you'd end up with $180,000.

Even as the lower cost of index funds continues to lure investors, some experts point out that the growth of passive choices over the last 10 years has coincided with a still-ongoing bull market. In other words, when markets are generally rising — even with blips along the way — it isn't hard to do well with funds whose index posts gains.

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For example, the S&P 500 index — a broad measure of how U.S. public companies are faring — rose about 156% from the beginning of 2010 through Friday, when it hit a new high.

So for investors in, say, an index-based target-date fund or any other automated portfolio composed of passive funds, the strategy generally has worked in their favor.

At some point, though, if a stock slide results in a prolonged slump, gains could be harder to come by in ETFs and index options.

In that scenario, more money could head back to actively manage mutual funds, whose managers could move their investments around to mitigate losses, said CFP Alex Koury, a wealth advisor with ValuesQuest in Phoenix.

"In the next 10 years ... it's going to be more challenging to achieve the same types of returns," Koury said.

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