Investor disgust over paying high fees to fund managers who underperform market benchmarks is driving the growth of index-linked ETFs.
Being a professional investor is “the hardest profession on the planet” because of the constant and measurable competition against passive benchmarks, says John Standerfer, chief technology officer at trading firm S3.
“Benchmarks are the most ferocious of competitors. They show up for work every day. They never get sick. They don’t take vacation. They are always 100% invested so their results are continuously compounding,” Standerfer wrote at his blog.
“Most importantly, they’re not aware of their own performance. The S&P 500 will never enter the 4th quarter feeling it needs to really press to have good numbers for the year. Nor will it take December off to ‘lock in’ a good year,” he said. [ETFs Outperform Mutual Funds]
Most ETFs are index funds that can be bought and sold during the day, while mutual funds are priced once at the close.
ETFs can undercut index funds on fees and they also offer transparency and tax efficiency. More fee-based advisors are using ETFs as portfolio building blocks.
“There is nothing novel about the index versus active debate. It has been a contentious subject for decades, and there are strong opinions on both sides,” S&P Indices wrote in its 2011 year-end “scorecard” that measures the performance of active fund managers against their relevant benchmark.
“The only consistent data point we have observed over a five-year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices,” S&P concluded.
Standerfer points out that indices, as well as peer performance, put the pressure on active fund managers to produce results.
“Outside of professional sports, I’m not sure there is any other industry that generates such objective and continuous measurements. And even in sports, there is no equivalent of a ‘passive benchmark.’ If a player is struggling, teams do not have the option to replace that player with a benchmark that guarantees them the averaged production of every player at that position,” he wrote.
Investors can buy a portfolio of index funds or ETFs and “have a good chance to outperform not just a few, but the majority of mutual and hedge fund managers,” Standerfer said.