If You Can Beat Them, Why Join Them? ETFs As Viable Long-Term Investments

| About: SPDR S&P (SPY)

In today's news, the small investor is inundated with information regarding countries, companies, and macroeconomic predictions. With all this information, the small investor is left hopeless to sift through it all, in hopes of finding the particular asset that can secure retirement, pay for a child's education, or provide a stable life. To the small investor's detriment however, they don't have the time, expertise or inclination to study individual companies in hopes of determining which one merits their investment. Even more important, the few dollars the investor does have to invest, must be invested in a manner that does not lose any money over the long term. This retention of principal is of particular importance due to the tough macroeconomic circumstances prevailing today. Fearing that all is lost, the investor elicits the help of "expert" managers. These experts assure the hopeless investor that his principal will be preserved with the added promise of capital appreciation. However, as historic results have shown, these "experts" are oftentimes no more adept at picking stocks as they are at predicting future macroeconomic trends. Attempting to outwit one another, these experts are in fact hindering growth that would otherwise be obtained through simply sitting on the couch and doing nothing. So I pose this question to you, the investor: If you can beat them, why join them? In this article, I am going to show theoretically and mathematically why an index fund overtime is superior to that of mutual funds in general. I will then conclude with some general thoughts on current valuations.

In regards to the mutual fund industry overall, there are many practices that will harm the investor over time. Hidden fees, high asset turnover, transactions costs, taxes, and management fees all erode the investor's potential gain over time. In such instances, the investor must now work even harder to cover any losses incurred and still afford to live comfortably in retirement. I am not by any means suggesting that mutual funds are an impairment to society. In fact, I applaud the general acceptance and desire to create wealth by the general population. However, when juxtaposed against index funds, mutual funds are clearly inferior in many respects. As such, investors, particularly now, should be cognizant of the benefits of ETFs tracking particular indexes such as SPY or QQQ.

Let's begin with a simple yet very profound chart. Ignore for a moment the expense ratio column on the right. The chart indicates investor gains over a 30-year time horizon net of fees. Assuming a 10% compounding growth rate (roughly the historical average of the S&P 500), the investor will obtain the following rewards within the chart.

Chart 1

Initial Investment Final Amount Expense Ratio
10,000 $174,494.02 0%
10,000 $152,203.13 0.50%
10,000 $132,676.78 1%
10,000 $115,582.52 1.50%
10,000 $100,626.57 2%
10,000 $87,549.55 2.50%
Click to enlarge

What amount do you think is best for the investor? Upon inspection of the chart, a reasonable investor would obviously elect the first option of $174,494.02. What is occurring in real life however is exactly the opposite. The irrational investor, through many mutual funds, is electing instead to take the bottom option of $87,549.55. The investor is providing 100% of the capital, taking 100% of the risk, and receiving roughly 50% of the return. How does this secret theft of principal occur? The answer lies primarily within the expense ratio column on the right.

First, the notion of costs makes the index fund far superior to its mutual fund counterpart. Mutual funds have the unique ability to charge investors more money for NO performance. This pay-for-no-performance cost is embedded within the expense ratio column to the right of the chart. These expenses, mentioned earlier, range from high transaction costs as managers attempt to outwit one another, to tax implications from trading, to hidden 12b-1 fees, to simple asset management fees. All of which add little to no value in regards to the investor's overall return. In combination, these expenses can be anywhere from 2% to 4%. As such, the 2.50% expense ratio mentioned in the chart is rather conservative given the nature of mutual fund fees in the real world.

In many respects, due to high expense ratios, passive investors can beat "expert" managers who actively trade. In order to replicate the performance of the index, the mutual fund manager must subsequently beat the market by his own expenses. For example, if the market gains 10% in one year, the mutual fund manager with a 2% expense ratio must earn a 12% rate of return (12% return- 2% expense ratio=10%). This concept, over long periods of time, has been proven difficult to do for mutual fund managers. Their expenses are simply too high in regards to that of an index fund. As such, statistics have proven that investors in index funds beat 75% of the market simply through passive behavior. Remember, you as an investor get paid for inactive behavior while the mutual fund industry, traders and brokers get paid for active behavior (constant buying and selling). Simply by holding an index fund, the beginning investor can outperform many of the "expert" managers in the industry. I now pose the question to you again: If you can beat them, why join them?

Let's take a more detailed look at how the investor loses money with high mutual fund expenses. The following chart shows in more detail, the loss of principal that occurs due to high expense ratios. Notice that the longer the duration, the more money that is garnered from the investor.


Years 10% Gain 1% 2% 2.50%
0 $10,000 $10,000 $10,000 $10,000
1 $11,000 $10,900 $10,800 $10,750
2 $12,100 $11,881 $11,664 $11,556
3 $13,310 $12,950 $12,597 $12,423
4 $14,641 $14,116 $13,605 $13,355
5 $16,105 $15,386 $14,693 $14,356
6 $17,716 $16,771 $15,869 $15,433
7 $19,487 $18,280 $17,138 $16,590
8 $21,436 $19,926 $18,509 $17,835
9 $23,579 $21,719 $19,990 $19,172
10 $25,937 $23,674 $21,589 $20,610
$ Less ($2,264) ($4,348) ($5,327)
% Less -8.70% -16.80% -20.50%
11 $28,531 $25,804 $23,316 $22,156
12 $31,384 $28,127 $25,182 $23,818
13 $34,523 $30,658 $27,196 $25,604
14 $37,975 $33,417 $29,372 $27,524
15 $41,772 $36,425 $31,722 $29,589
16 $45,950 $39,703 $34,259 $31,808
17 $50,545 $43,276 $37,000 $34,194
18 $55,599 $47,171 $39,960 $36,758
19 $61,159 $51,417 $43,157 $39,515
20 $67,275 $56,044 $46,610 $42,479
$ Less ($11,231) ($20,665) ($24,796)
% Less -16.70% -30.70% -36.90%
21 $74,002 $61,088 $50,338 $45,664
22 $81,403 $66,586 $54,365 $49,089
23 $89,543 $72,579 $58,715 $52,771
24 $98,497 $79,111 $63,412 $56,729
25 $108,347 $86,231 $68,485 $60,983
26 $119,182 $93,992 $73,964 $65,557
27 $131,100 $102,451 $79,881 $70,474
28 $144,210 $111,671 $86,271 $75,759
29 $158,631 $121,722 $93,173 $81,441
30 $174,494 $132,677 $100,627 $87,550
$ Less ($41,817) ($73,867) ($86,944)
% Less -24% -42.30% -49.80%
Click to enlarge

Another expense that is rarely mentioned is that of taxes. Taxes are indeed an expense as they take money away from the gains generated from the individual investor. Nobody mentions the tax implications of mutual funds as a detriment to the individual investor. In fact, many simply accept taxes as a given. Due to many of the new tax laws introduced by congress, taxes now have a more profound impact on the investor's future returns. The small investor, however, should be concerned as well. Mutual funds are very expensive in regards to taxes. Mutual funds buy and sell new securities almost yearly. This "turnover" as it is called, causes useless tax burdens on the individual investor, which erodes future gains. Turnover is calculated primarily as the percentage of holdings that change each year. For one, by buying and selling, the mutual fund manager is causing capital gains tax on the same people who are providing cash for the manager to invest. This causes higher commission costs as well that are borne by the consumer or purchaser of the mutual fund. Below is CHART 3 which was provided by Stubel Investment Management, LLC. This chart depicts how turnover can affect the value of an initial $10,000 investment.

Chart 3

Click to enlarge


HOW TO READ THE CHART: The blue lines are the values of a $10,000 investment each year for 20 years. The red lines are the value of a $10,000 investment if the securities are bought at the beginning of the year, and sold at the very end of the year for 20 overall years.

Because index funds are passively managed as oppose to actively managed, there is little need for all the fees associated with mutual funds. In fact, the expense ratios are so low, that they pale in comparison to the extreme expenses of the mutual fund industry. This has profound implications for the individual investor as he can now retain a greater percentage of his returns for himself as opposed to giving it away to others in the form of fees. In addition, index funds have very little turnover, again saving the investor money in the long term. The components of an index rarely, if ever, change. Participants may enter into the S&P 500, but do so only if they are a strong, reputable company. Not all companies are qualified to enter the S&P 500. As such, very few companies leave this benchmark index. Even if a company does leave the index due to bankruptcy, a very low stock price, or by some other circumstances, the index is automatically adjusted to compensate for this. In fact, most of the work is conducted by computer without the involvement of human error or judgment. This provides reassurance to the individual investor that his money is being used as efficiently and as cost effectively as possible. This ultimately helps the investor obtain superior financial performance relative to his peers.

Now, a little on current valuations. I personally make no attempt to predict macroeconomic factors. I am, however, very bullish on the American future of equities. Many pundits are quick to point out that the S&P 500 has gained very little over the past decade. I believe this assessment to be only partially correct. The market value of the securities has increased very little, but the underlying value of the companies has increased dramatically. Companies now have better balance sheets, more cash reserves, lower expenses, and lower amounts of debt. They continue to innovate and create products that are demanded by society. McDonald's (NYSE:MCD) is now selling more burgers than it did a decade ago. Hershey (NYSE:HSY) is now selling more candy bars than it did a decade ago. Coca-Cola (NYSE:KO) is selling more beverages now that it did a decade ago (1.62 billion 8 ounce servings a day!). The market valuation in some instances may not reflect an optimistic future. In many instances, it may reflect a more pessimistic one. However, the underlying business continues to generate strong earnings, and solid returns on equity. I believe much of the pessimism prevailing in the market is misplaced.

I present to you a very interesting market fact. At the start of year 1900 the Dow was trading at roughly 67 points. At the start of the year 2000 the Dow was at 11,400. Over that 100-year time frame, the passively managed index fund would have made the investor and the investor's family very wealthy. During the 100-year period, however, we had 2 world wars, an oil embargo, hyper inflation, a great depression, civil unrest, terrorist attacks, presidential assassinations and much more. The country even had a period of 17 years where the market didn't increase in value at all. However, the market continued to rise through the long term. Now 100 years later, America is living better and more prosperously than it did 100 years prior. I believe the same is true today. By purchasing an index fund today, you, the investor, are placing a bet on the future of America. This bet has proven to be very profitable over the past 200+ years, and shows signs of doing so for the considerable future. During this 100 time frame, the opinions of mutual fund managers and expert economists didn't matter. The businesses themselves ultimately determined value. So I conclude with posing this question to you yet again: If you can beat them, why join them?

Disclosure: I am long SPY, QQQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.