August 16, 2018

ETF Index Error 2: Asset managers underperform the index

Do you remember the children from our last blog that raced each other in a 100-meter race for a charity event? The guests had the option of betting their donation on an individual child or a group of children, while the 10 tallest children – and their finishing times – were pooled into a group called the "Big Kid Index".

Now it’s your turn to make a selection of children that will beat the Big Kid Index. Or more specifically: it's performance. Your selection should, therefore, score a better average finishing time than that of the index. Now there are countless methods for creating sub-groups of the Big Kid Index, and some of them will beat the Big Kid Index.

However, on average, no selection can reach a faster finishing time than the overall group. Measured as a whole, the children cannot run faster only because they are categorized into specific groups. If we create enough groups, then their combined performances, meaning their average finishing times, will always be the same as the overall average.

The same applies to stocks: Investors as a whole can never beat the index because the selection of stocks doesn’t generate additional returns. For this reason, the entire group of actively selected asset managers is always just as good as the index. Only the asset management costs can make a difference.

The low costs are then the only real advantage of exchange-traded funds, the index funds that are traded on the stock market and are also called ETF. However, if you buy stocks yourself, then your costs are even lower than those of the index funds because you’re saving their administration fees.

So since ETF only have the cost advantage and aren’t statistically superior to other stock groups, the question is how good the stock selection in these funds really is. We will discuss this next week on this blog. Stay tuned!

ETF Index Error 1

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