A fact that few people realize is that so-called "active fund managers" – the people who manage a mutual fund’s investments and try to generate returns by doing so – rarely beat the market. In fact, a recent study in the Journal of Finance found that only 1 percent of active managers outperformed the returns of their benchmarks, while almost a quarter managed to destroy value.
Part of the problem is fees, which can be particularly damaging to the relatively small portfolios of younger investors. Even if a manager is beating the market, the person to whom the investments actually belong might pay all their profits to the manager and end up no better off.
Fortunately, a relatively recent financial innovation can solve this problem. It’s summed up in three letters: ETF, which stands for exchange-traded funds. An ETF trades just like a stock on a major exchange – it can be bought and sold every day. These "passive" funds track most of the major industries, commodities and markets in the world. Whether it’s the S&P 500, gold, the technology sector or Brazilian heavy industry, there is an ETF pegged to it.
Essentially, a company like State Street or Vanguard will buy the stocks of the underlying companies for a fund – say, the S&P 500-tracking "SPY" fund – and then issue shares of that fund on the market. The price of SPY will track that of the S&P 500 index – when the index goes up, your shares are worth more, and vice-versa.
This lets you own an asset that performs exactly the same as the benchmark, which most managers can’t even beat, without having to pay anything other than a very low expense ratio built into the price of the stock. It makes investing in big markets or sectors really simple, because one asset encompasses the entire portfolio.
You can pick your ETFs to mix and match your risk tolerance, as well. If you’re willing to put more potential losses on the line, funds like the S&P Emerging Markets ETF (GMM) and S&P Emerging Latin America ETF (GML) offer greater returns from high-growth emerging stock markets.
On the other hand, low-risk ETFs, like the iShares Lehman 1-3 Year Treasury Bond ETF (SHY) and the Vanguard Short-Term Bond ETF (BSV), are pegged to super-safe Treasury or AAA-rated bonds. Though they rarely show huge gains, they are unlikely to lose value either.
ETFs are the perfect tool for the young investor, who can’t afford to waste any money on an expensive fund manager who can’t even manage to beat the markets.