U.S. stock investors reached a milestone last year. For the first time, money invested in stock index funds and exchange-traded funds (ETFs) exceeded the amount in actively managed U.S. stock funds, according to Morningstar Direct.
That's a sign that individual investors are getting smarter. Index mutual funds and ETFs are "passive," aiming to track a benchmark, such as the S&P 500 index.
Passive funds cost less to own, and that is a big reason why they typically deliver better returns than actively managed funds. While the manager of a mutual fund may be able to outperform a rival index fund or ETF for a year or two (or more), the data are clear that it's exceedingly hard for active funds to consistently do better than passive funds over long stretches.
According to Morningstar, in the 10 years through the middle of 2019, fewer than one in four active funds did better than index funds or ETFs.
Morningstar reports that at year's end, 51.2% of equity-fund money was riding on passive, close to 49% sticking with active management.
If you still have a chunk of money riding on active, it's worth asking yourself why.
The vast majority of index mutual funds and ETFs charge an annual fee, called the expense ratio. (Fidelity recently launched four zero-index funds that waive the fee.)
The expense ratio is embedded in the fund's accounting; you won't see it as a separate line item in your statement. But it's easy to find. Log into your account, or do a web search of a given fund or ETF. The expense ratio will be displayed on the first page. It is reported as the percentage of the fund's assets that are deducted to cover fund costs.
The encouraging news is that investors are paying a lot less than in years past. Morningstar reported in its most recent fee study that the average asset-weighted expense ratio for all funds was 0.48% in 2018. That is half the average expense ratio in 2000.
But dissecting the 0.48% exposes the big advantage of passive funds. According to Morningstar, the average asset-weighted annual fee paid by passive investors in 2018 was 0.15%. For active investors the average was 0.67%.
Seems small, but it's a huge deal. Let's say you have an active stock fund and a passive stock fund. Before dealing with the annual expense ratio, both generate a gross annualized return of 5%.
Now let's subtract their respective expense ratios. The net return for the active fund is 4.33% (5% minus 0.67%), and the net return for the index fund after subtracting the 0.15% expense ratio is 4.85%.
Over 30 years, $100,000 invested in the more expensive active fund will grow to about $357,000 based on a net annualized return of 4.33%. The same $100,000 invested in the less expensive passive index fund or ETF will grow to $414,000. That's $57,000 more without taking on any additional risk. Kind of a big deal, eh?
If you are compelled to move more of your money into passive funds or ETFs, there will be no tax bill if you make the move inside a 401(k) or IRA. You can "exchange" investment A for investment B, C and D inside retirement accounts without any IRS bill.
Moving money around in a regular taxable account can trigger a tax bill. In the eyes of the IRS, when you move money out of fund A, that is considered a sale, regardless of the fact that you are moving the money into fund B (a purchase.)
Carla Fried writes for Rate.com.
