Exchange-Traded Funds Coming to a 401(k) Near You
Here is something that is as true as it gets: There is really no reliable way to beat the market. More often than not, those who try end up failing and underperform the benchmarks against which they are racing.
Outside of plain incompetence, there are two main reasons why. Writing to the then-publisher of the Washington Post, Kay Graham, in 1975, Berkshire Hathaway Chairman and CEO Warren Buffett explained the first: “A little thought, of course, would convince anyone that the composite area of professionally managed money can’t perform above average. Estimates are now that about 70% of stock market trading is accounted for by professionally managed money. Any thought that 70% of the environment is going to substantially out-perform the total environment is analogous to the fellow sitting down with his friends at the poker table and announcing: ‘Well, fellows, if we all play carefully tonight, we all should be able to win a little.’”
Since the financial industry has done nothing but gorge itself on American wealth over the past 40 years, it is likely that Buffett’s words are more true today than they were back then. As the financial sector increased in complexity, the financial services industry grew to accommodate it, and the average investor doesn’t have to look very far to find a fund manager advertising market-beating returns.
But beating the market is not impossible — just hard — and people like Buffett prove that it’s possible, even over a long timeline. Buffett’s conglomerate holding company reports a compounded annual gain of 19.7 percent since 1965, more than double the 9.4 compounded annual gain of the S&P 500, including dividends.
Most money managers are not so skilled or lucky, though. A study conducted by NerdWallet using data from 2012 showed that active fund managers managed to beat the market by an average of just 0.12 percent over the past 10 years. However, since the fees charged by active fund managers are so high, only 24 percent of professional investors actually managed to beat the market over the past decade. Index funds ultimately outperformed actively managed funds by 0.8 percent annually. So fees are the second reason why it’s hard to reliably beat the market: The only people who can pull it off charge enormous fees for their services.
These realities have made passive funds, such as exchange-traded funds (ETFs), increasingly popular over the past several years. The Investment Company Institute reported at the end of January that the combined assets of the nation’s ETFs grew by 25 percent on the year to $1.67 trillion. This is still well below the approximately $15 trillion in assets tied up in mutual funds but still represents a sizable share of the investment universe.
In order to service the increasing demand for ETFs, Charles Schwab launched an all-ETF 401(k) program on Wednesday, the first major firm to do so. “We believe workers can and should get more value from their 401(k)s,” said Steve Anderson, head of Schwab Retirement Plan Services, in a press release. According to Anderson, using ETFs can reduce 401(k) expenses by up to 90 percent because they don’t need to be actively managed.