Why ETFs and Index Funds are NOT the Queen of the Ball

ETFs (exchange-traded funds) and index funds are the reigning queens of the ball. Why? Many investors and financial analysts believe that passive investing is the secret sauce for investing. They argue that ETFs and index funds produce better returns than managed funds because of the “indexing” advantage.

For those unfamiliar with the difference between ETFs, index funds, and managed funds like mutual funds, here is a brief overview:

Both index funds and ETFs fall under the “indexing” investment strategy. Both involve investing in an underlying benchmark index. There is very little active management involved – hence the passive label. A benchmark index is selected, and the machines do the rest to track the ETF with the index. For example, SPDR S&P 500 ETF (SPY) tracks the S&P 500 Index.

Although ETFs and index funds are very similar, they have one major distinction between them.

Index funds are mutual funds without the high management fees, and ETFs are traded like stocks. Whereas ETFs have a price and are traded during the day, the price at which you might buy or sell an index fund isn’t a price – it’s the net asset value (NAV) of the underlying securities. And you’ll trade at the fund’s NAV at the end of the trading day. 

The primary reason for indexing is that index funds and ETFs can often beat actively managed funds in the long run. Not only have index funds and ETFs outperformed managed funds, but the fees associated with a passive fund are also markedly lower than active funds.

Index funds and ETFs tend to be more tax-efficient and have lower expense ratios than actively managed funds because they generally trade less frequently. That’s because they’re not designed to beat the market. They’re merely tracking an index.

Active funds, on the other hand, attempt to beat the market resulting in a higher frequency of trades that often miss their goals, resulting in losses for the fund – and its investors.

Maybe ETFs and index funds are getting all the attention at the ball because the competition isn’t all that pretty.

Standing next to ugly mutual funds will make the passive ETFs and index funds stand out, but here’s the problem with ETFs and index funds. They play in the same Wall Street sandbox as active funds. However, if a bear tears through that sandbox in the form of a market downturn, ETFs and index funds are no more protected than active funds are.

When things are good, you may make a little more with passive funds vs. active funds, but when things go south, there’s no protection. ETFs and index funds are made up of stock just like mutual funds. Given the high correlation between the stock market and the broader economy, a downturn can mean disaster for ETFs and index funds just like for stocks in general.

Maybe that’s why Michael Burry of “Big Short” fame is sounding the alarm on ETFs and index funds – calling the strategy a bubble that is too focused on large, established companies that are too tightly associated with the broader market that is ripe for a downturn. Winck, Ben (Aug. 28, 2019) ‘Big Short’ Investor Michael Burry Predicted the Housing Crisis. Now He’s Calling Passive Investment a ‘Bubble.’ Retrieved from https://markets.businessinsider.com.

The real queen of the ball is the one that nobody expected and is often overlooked. Many investors are on the right track with passive investments, but most don’t go far enough.

It shouldn’t be enough that an investment is passive, but it should also produce passive income. Many ultra-high-net-worth investors (“UHNWIs”), tired of the same mix of stocks, bonds, mutual funds, ETFs and index funds, are seeking out passive options with better returns but without the added risk. And what these investors and UHNWIs are discovering are alternative investments to replace the public markets.

Passive alternative assets are not correlated to the stock market, offer diversification and potentially higher returns when compared to mutual funds, ETFs, and index funds.

Alternatives such as real estate, have historically provided higher returns at a lower risk.

By targeting indirect investment opportunities in real estate offering above-market returns uncorrelated to Wall Street, successful investors are generating wealth through a truly passive investment generating passive income.

So if passive alternative investments like opportunities in private real estate funds are the true queen of the ball, why do so many retail investors ignore them.

The truth is these opportunities used to be only available to the wealthy and connected. Many retail investors may believe these opportunities are out of their league.

Although once the province of institutional investors and UHNWIs, alternative investments are now more accessible to the regular investor than ever before, thanks to recent regulatory changes.

As the barriers to access come down, individuals can now take advantage of this investment class that has long provided above-market returns and shelter from Wall Street volatility.

So, for a truly passive investment – one that provides passive income as well as appreciation and shelter from volatility – look to passive alternative investment opportunities like a private real estate fund and ignore ETFs and index funds.

Take control of your portfolio and invest with intention.

Kyle Jones

About the author

Investor, writer, speaker, and founder. Kyle Jones, key principal of TruePoint Capital, is accountable for investment decisions, asset management, and overseeing financial activities, operations, and investor relations. Kyle additionally is a Global Sales Leader for a large Fortune 100 technology company. Kyle received a Bachelor of Science degree from Texas State University – San Marcos.