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For investors taking the passive approach, there are over 1,500 ETFs to choose from with a number of unique opportunities, including ETFs focused on spin-offs and merger-arbitrage opportunities. Wading through all the "noise" can be time consuming and confusing. We want to make things even simpler for investors, helping them efficiently invest on their own. So what we hope to address is whether it's worthwhile to simply invest in ETFs.

Our Conclusions

  • The Nasdaq Composite outperformed the S&P 500 and Dow Jones Industrial Average in 48% of the months over the past decade
  • The S&P 500 has outperformed the Dow 30 by 0.4% annually over the past decade
  • Investing in one of the major indexes is just as efficient as a balanced passive or active fund, and better than a global ETF
  • S&P 500 ETFs have the lowest expense fees
  • On a risk-adjusted basis, the Nasdaq Composite has been the best performing major index over the past four decades
  • Small-cap stocks tend to be more volatile, but don't necessarily generate higher returns
  • Many major ETFs track their underlying index very closely

Index Performance

Let's dig a bit deeper into the three most popular indexes covered by every major news sources worldwide. These include the S&P 500, Dow Jones Industrial Average and Nasdaq Composite. The three indexes pretty well traded in tandem through the 2000s, following the dot-com bubble burst. However, following the real estate bubble bursting, there has been a slight dichotomy amongst the indexes. The Nasdaq has outpaced the other two, while the S&P 500 appears to be lagging.

Click to enlarge images.

Interestingly enough, if we dig a bit deeper, it's the Nasdaq Composite and Russell 2000 that have provided investors with the best return over the last decade:

In the chart below we see that the major indexes, the S&P 500 and DJIA, have performed in line with both the active and index funds:

Although the S&P 500 and DJIA have underperformed the index funds, on a risk-adjusted basis (return divided by volatility), the broad indexes perform similarly:

So, what does this tell us? In essence, the S&P 500 or DJIA have provided investors with the same risk-adjusted returns as index and active funds. What this means is that investors could essentially invest in the S&P 500 and get the same risk-adjusted returns, vs. trying to navigate the vast ETF and mutual fund universe.

Major Indexes

Here are the major indexes we looked at (from above); chances are you hear these names quite often.

The Dow Jones Industrial Average (DJIA) includes the 30 stocks of some of the world's largest companies, with the index being about 25% of the entire U.S. stock market value. The S&P 500 is larger and more diverse than the DJIA, consisting of 500 of the most widely traded stocks in the U.S. -- and being about 70% of the total value of U.S. stock markets. The Nasdaq Composite covers primarily tech stocks. The index has over 5,000 companies, and unlike the DJIA and S&P 500, includes some smaller speculative companies.

A couple of other less talked about indexes include the Wilshire 5000 and Russell 2000. The Wilshire 5000 covers the "total stock market," encompassing the over 7,000 companies that are publicly traded and headquartered in the U.S. The Russell 2000 covers 2,000 of the smallest stocks from the Russell 3000, being known for including small companies.

Let's take a closer look at how the indexes have performed over the past decade.

The Nasdaq and Russell 2000 managed to outperform the other indexes. Meanwhile, on a risk-adjusted basis, the S&P 500, DJIA and Wilshire 5000 all performed relatively in line with each other.

Risk

Let's dig a bit deeper and compare the major indexes on some other risk measures.

Based on the Sharpe ratio, which takes into the account how the index has performed relative to the risk-free rate, both the Nasdaq and Russell 2000 continue to outshine the other indexes (the higher the Sharpe the better).

Taking the idea of looking at a risk a step further, let's take out the upside deviations (volatility). Why should the index be punished for outsized returns on the upside? Well, they shouldn't; let's introduce the Sortino ratio. We looked at the standard deviation of the indexes, only accounting for returns on the downside (hence the downside deviation from above). Again, the higher the Sortino ratio, the better. In this case, the Nasdaq continues to outshine its major index peers.

Now let's zoom out a bit and take a longer-term view of exactly how the indexes have performed since 1971 (since 1987 for the Russell 2000).

Now we see that the Nasdaq really puts some separation between itself and the other major indexes, with Sharpe and Sortino ratios that are well above the competing indexes.

How Much Do I Owe?

Costs, costs, and costs are by and large one of the biggest issues for mutual fund investing. These costs eat into your return, and they are the main reason why the majority of funds end up with sub-par performance. There are various fees that include expense fees, but there are also those pesky loads -- fees you pay when you buy or sell shares. There is also the slight issue of underperformance, meaning professional money managers actually create little value beyond what the market is able to generate. Mutual funds have various fees, including front end (fee for just buying the fund) and back end (fee for selling).

Although ETFs are much cheaper than conventional fees charged by mutual funds, they still have to charge a small fee to cover trading and admin costs. The expense ratio is the amount ETF investors are charged, measured as a percent. The average index fee is 0.15%, and some of the ETFs below have higher than average fees, so watch out for this.

It Just Takes One

So investors don't really need fancy ETFs or "highly" diversified mutual funds to outperform the market? As seen from the table above, the S&P 500 performed in line with the universe of active and index funds; a simple investment in the S&P 500 or even the Dow 30 would have yielded similar results. The problem is that many of the ETFs and index funds don't always track their underlying index. Of course, if they did there wouldn't be multiple ETFs tracking the same index. Let's have a look at the major ETFs that are following our key indexes.

Wilshire 5000

Although the Wilshire 5000 covers the broadest range of stocks, the problem with investing in the Wilshire is finding an ETF that tracks the index. ETFs that try to track the broad U.S. stock market include the Vanguard Total Stock Market ETF (VTI), iShares Dow Jones U.S. Index Fund (IYY), Schwab U.S. Large-Cap (SCHX) and Schwab U.S. Broad Market (SCHB).

What looks to be investors' best shot at gaining exposure to the Wilshire 5000 is the SCHB, which also has an impressively low 0.04% expense ratio.

DJIA

The top Dow Jones Industrial Average ETF is SPDR Dow Jones Industrial Average (DIA), and its beta with the DJIA Index is 0.99. But there, again, we are not big fans of the expense ratio, which is 0.16%.

Russell

Although the Russell doled out impressive returns since being created in 1987, for those looking to dabble in the small-cap area you're going to have to pay for it. The fees for ETFs tracking the Russell 2000 are quite high when compared to the other major indexes. However, both the available ETFs are highly efficient in tracking the index. iShares Russell 2000 Index (IWM) has an expense ratio of 0.28% and has a beta with the Russell 2000 of 0.99. The relatively new and much smaller Vanguard Scottsdale Funds (VTWO) also tracks the Russell 2000 with a 0.99 beta and it has a 0.21% expense ratio.

Nasdaq

The ETF for the Nasdaq is the Fidelity Nasdaq Comp. Index (ONEQ), which trades with a beta of 1.02. But, the expense ratio is 0.3%. If you are still interested in investing the tech index, we think the PowerShares QQQ Trust (QQQ) is by and large your best bet. The expense ratio is also only 0.2% compared to ONEQ's 0.3%.

Although the QQQ is the 100 largest companies from the Nasdaq Composite (which has 1,000 stocks total), what's impressive is that when compared to the Nasdaq the QQQ has a beta of 1.02 with an R-square of 0.96, meaning it tracks the Nasdaq quite impressively. But the story gets better. Over the past decade, the QQQ has outperformed the ONEQ not only in pure returns, but also risk-adjusted returns.

Yet, there is a caveat with higher volatility ETFs, such as the Russell and Nasdaq. The thing about higher volatility is it plays on investors' emotions. Timing is everything. Increased volatility (ups and downs) tends to lead investors to premature selling.

You take away the Nasdaq's three best months and its annualized return over the 34-year period falls over 100 basis points from 12.7% to 11.6%.

S&P 500

Some of the most notable ETFs tracking the S&P 500 include the SPDR S&P 500 (SPY), iShares S&P 500 Index (IVV), and Vanguard 500 Index Fund (VOO). All three have a beta compared to the S&P 500 of over 0.98. The beauty about the S&P 500 ETFs is that they are heavily followed and invested in, which helps the brokerage firms offer these ETFs with much lower expense ratios when compared to the likes of DJIA and Nasdaq ETFs.

How do the ETF fees stack up? SPY has an expense ratio of 0.09%, IVV at 0.07%, and VOO at 0.05%.

What About Global?

What about those investors that say "What about international exposure?" Well, truth be told Coca-Cola (KO), a S&P 500 and DJIA component, gets over 55% of its revenues from outside of North America. Coca-Cola isn't the only one. But for the sake of arguing, let's see just how the S&P 500 stacks up against the major global ETFs.

Let's look at some of the top global ETFs. A few include the Vanguard Total World Stock (VT) iShares MSCI ACWI (ACWI) and iShares S&P Global 100 Index (IOO). The comparison time frame will vary for each given many of these global ETFs are newer products, but we adjust the S&P returns to allow for an apples-to-apples comparison.

Outlined below are the returns for the S&P 500 compared to the global ETFs:

The S&P 500 has managed to hold its own on compared to all the major global ETFs. The IOO has been around for the last decade and appears to be a solid bet for investors looking for international exposure. However, one of the problems is that IOO has one of the highest expense ratios around at 0.4%.

For a risk-adjusted return, you're getting the same results, but instead of paying 0.4% in expenses, you're only paying 0.09% by investing in the SPY (an S&P 500 ETF). Sure, the 0.31% difference doesn't sound like much, but that difference compounded over 10 years would add 3.7% to your total return.

What to Do?

Indexing not only saves time, but it's relatively straightforward. You know what you're investing in and the liquidity is generally much better.

If investors were going to choose just one index to invest in, it looks as if you can't go wrong with the S&P 500. Not only does the index offer solid exposure to the U.S. markets, but over the last decade the company has returned similar growth with the same risk-adjusted metrics as diversified active and index-managed funds. For investors looking for a bit more bang for their buck (increased volatility), the Nasdaq index could be just what you're looking for.

Source: Half The Time, The Nasdaq Wins Every Time